A lease is a contract. By its terms, the “Lessor” (Leasing Company) gives the “Lessee” (The Customer) the exclusive right to use and possess its equipment for a specified period. In recent years, equipment leasing has become an accepted and economical source of financing. A lease can finance the acquisition of equipment or act as an additional source of working capital. In this respect, it acts as an alternative to traditional debt financing. The lease contract may be a single transaction involving specific equipment, or it may be written as a “master” lease with a continuing arrangement, on specific equipment having separate schedules executed from time to time. In either case, the contract will require the lessee to make periodic payments (or “rentals”) to the lessor for the use of the leased equipment.
There are basically three types of purchase options:
FAIR MARKET VALUE (True Lease): This purchase option is the most commonly used purchase option since it has the most tax advantages and options at the end of the lease. At lease end, the lessee has the option to continue to lease the equipment, return the equipment, or purchase the equipment at its fair market value.
10% PURCHASE OPTION: This option establishes a fixed purchase price at the end of the lease. The customer has the option to purchase the equipment for 10% of the original purchase price, continue to lease it, or upgrade the equipment.
$1.00 PURCHASE OPTION: This option is for those who want to have a nominal purchase option at the end of the lease term. They simply pay $1.00 plus a small charge for the processing, primarily if any title transfers are required. The lessee is typically treated as the owner of the equipment for tax purposes. As with any financial decision, we suggest you consult your accountant when determining what type lease structure is best for your particular situation.
In a Capital Lease, the Lessee is treated as the owner of the equipment for tax purposes. Therefore, it can claim depreciation deductions on its tax return. On the other hand, in a Operating Lease, the Lessee is not the owner of the equipment for tax purposes. It cannot claim depreciation deductions on its tax return. Nevertheless, because the Lessor is entitled to the tax benefits on the equipment, the Lessee will benefit from lower rental payments, often below market rates. In addition, the lessee normally would receive deductions for the full amount of rental payments on its tax books.
“Cash flow” is the normal flow of cash into and out of your business. Increasing cash flow may simply mean reducing payments to be made by your business. Often, leasing companies assume that equipment will have a residual resale value at the end of the lease and reduce the rental payments accordingly. This too produces a real cash savings. Finally, a Operating Lease can help an AMT taxpayer avoid additional minimum taxes, which would otherwise be due if the taxpayer owned the equipment. MACRS depreciation creates tax preferences but lease payments or rentals do not. This avoidance of minimum tax liability may be a real current cash savings, which is especially important because all taxpayers must pay their estimated minimum tax liability to the IRS on a quarterly basis.