Buying machinery or equipment you are currently leasing may not pay off.
In order to enhance its balance sheet for financial reporting purposes, a firm chose to lease a tanker rather than own it. After about 10 years, the company decided the lease was too big a burden, so it bought the ship by using an option in the rental agreement. The terms were awful.
The firm ended up paying more than the vessel was worth to break the lease. It then turned to Uncle Sam and tried to write off the portion of the purchase price that exceeded the fair market value of the ship. The firm said this access was a payment to get out of a burdensome lease and was therefore an immediately deductible business expense. The tax court didn't agree. It said the entire purchase price must be capitalized and depreciated over the life of the ship.
This is but one example of the kind of leasing traps that await the unwary. There are many others.
Reality checkAlthough leasing equipment may be the smart thing to do under certain circumstances, it's no panacea, according to Chuck Wold, president of the Wold Consulting Group, of Phoenix. Wold contends that business owners often make the mistake of thinking that leasing costs less than buying. That's what the sales representative for the leasing company wants you to believe but it's not necessarily true.
"Never," says Wold, "assume that a lease will cost less than an outright purchase."
He advises doing a "lease vs. buy" comparison whenever considering the acquisition of new equipment. A very common mistake made by business owners, according to Wold, is the approach they take toward acquiring a postage meter. Wold notes that most of the components of postage metering can (and should) be purchased. It's cheaper. But few business owners consider that option and don't expect the sales representative for the meter company to suggest that to you. Wold believes you can save a few thousand dollars over the term of a postage-metering lease by purchasing the equipment.
The simplicity of a lease is what prompts many a business owner to sign on the dotted line. There is no question that it's easier to lease a $25,000 piece of equipment than it is to buy the same equipment. No depreciation calculations, no financing to arrange and there is even the possibility--the sales rep says--of a large tax deduction. What a deal!
According to Wold, there is no free lunch. The only way to obtain a larger tax deduction for an equipment lease is by paying more for the lease than an outright purchase. Think about it. The cost of the equipment is tax deductible, so are the financing costs. Therefore, if a lease ends up producing a larger tax deduction than an outright purchase would, it's because the lease is costing you more.
Wold also notes that in some situations, you can write off your costs faster by buying the equipment. That's because of the Section 179 expensing allowance that permits you to deduct on your tax return--right away--up to $24,000 per year for equipment acquisitions in 2001. With a lease, your tax deductions are on a "pay as you go" basis. Whatever your lease cost for the year is, that's what you can deduct. With a piece of machinery or office equipment that costs $24,000 or less, you can write it off all at once.
Of course, the convenience factor is real. With a lease, you have one-stop shopping. You do not have to arrange financing or calculate depreciation. You just tell the sales representative what you need and he or she gets it for you--at a price. These services do not come free. And do not forget, just as you would have to borrow money to finance the acquisition of equipment purchased, so does the leasing company. That means that their financing costs, plus a profit, will be factored into the lease price.
One advantage frequently cited for leasing is that it does not tie up your capital and/or credit line. If obtaining credit and/or capital is a problem for you or you've used up all the credit your bank will give you, then this advantage is real. Otherwise, it's not that important a consideration.
If a company is structured as a corporation, the lessor may require a personal guarantee. After all, what leasing company wants a commitment from a corporation when it can get a personal commitment? If you decide to relocate your business and the new location necessitates a different equipment configuration, you could be personally liable to honor a lease you no longer care to have.
One misconception about leasing is that it makes your balance sheet look better. One business owner had a rude awakening recently when he tried to borrow some money for a business venture. The bank loan officer scrutinized the business owner's personal balance sheet. Although his accountant did not reflect the lease as a current liability, it was identified in a footnote. The result: a red-faced business owner who appeared to be trying to hide something.
"The notion that a lease will improve your financials is poppycock," Wold says.
Bear the burdenA lease is a financial obligation no matter how you slice it and leasing vs. buying will not enhance your borrowing capability. Leasing represents a commitment that you may come to regret. If you decide you no longer want the equipment because better equipment is now available or simply do not like the equipment leased, you are stuck with it until the lease runs out.
"If you have a 36-month lease and decide to terminate after three months, the leasing company will insist that you pay them the full 36 monthly payments," Wold adds.
Wold says this is really not surprising. If you do not want the equipment, there is probably a good reason. Chances are the leasing company will have difficulty finding someone who will want the equipment. So what will they do with the equipment? They have to insist that you fulfill your lease obligation.
Wold remembers one client who signed a long-term lease because the monthly charge dropped considerably when compared to a short-term lease. What his client failed to consider was the distinct possibility that he might not want that equipment for that length of time. In today's environment, with new technology popping up every other day, it's risky to lease anything that's "high tech" for any length of time. If a piece of construction equipment becomes technically obsolete, not only are you stuck with the financial burden of leasing equipment you no longer want, but will also have to go out and obtain up-to-date equipment in order to remain competitive.
Another problem comes at lease termination. You are expected to return the equipment in "satisfactory" condition. What if you have been harsh in your use of the equipment? What if the leasing company says you have been harsh on the equipment but you do not think so? Who decides the condition of the equipment at lease termination and what it's worth?
Leasing contracts contain penalty clauses for "misuse of equipment." This is not a fairy tale--leasing companies do invoke this penalty clause if they think the equipment is not as it should be. Some unscrupulous leasing companies always find something wrong with the equipment they have leased out. And they have your deposit, so you are at a distinct disadvantage. Of course, you could take them to court, but then, wasn't simplicity the reason for leasing in the first place?
Another snare Wold cautions about is the "tax trap." If a lease has a provision that allows you to purchase the equipment at lease end, be careful. If the IRS thinks the repurchase price is a "sweetheart deal," it can recharacterize the lease as a purchase. Guess what happens then? The IRS disallows the lease payments and requires you to capitalize (depreciate) the equipment and deduct the imputed interest. Not only is such a scenario a pain in the neck, but you will probably wind up with a larger tax bill.
Other pitfallsOften, business owners think only of their monthly cost, not their total cost over the life of the lease. Wold mentions a recent situation involving the lease of a copying machine. The sales representative presented the business owner with a cost-per-copy price that sounded quite reasonable. What wasn't discussed was the minimum monthly cost and the total cost over the life of the lease. When the business owner sat down with Wold, he learned to his dismay that had he signed the lease proposed to him by the copying machine sales representative, he would wind up paying $50,000. Not only is that an enormously excessive amount, but it's also an unneeded liability.
Wold advises that no matter what kind of equipment you are considering leasing, whether it's a copying machine or a postage meter, get at least two or three competitive bids and do not consider only the monthly cost--think about the total liability. Whenever possible, do not sign a lease for a longer period of time than is practical.
"The salesmen try to lure you," says Wold, "into a long-term lease by dropping the monthly charge as the lease term extends. But what are you going to do with a postage meter for five years if you're retiring in two years?"
Another mistake that's often made is losing sight of how long your original lease term is for. If you have equipment that's on a three-year lease and you are now into year four, you are probably paying more than you have to. Wold advises business owners to keep a sharp eye on when their leases expire. Once a lease expires, you are in the driver's seat. You can usually negotiate a better price or an equipment upgrade, sometimes both.
The bottom line is that no lease should be taken lightly. Make sure your lawyer and accountant have a chance to review any lease that commits you to substantial payments.