Every business is unique and has a unique set of objectives and needs. It is important to understand the two most common forms of lease financing, operating leases and capital leases, in order to make the best decisions for your business.
Operating leases involve terms shorter than the depreciable life of the leased equipment, as defined by MACRS accounting rules. Operating leases let you enjoy the full use of the leased equipment over a majority of the equipment's useful life-and at a substantial discount to the purchase price of the same equipment. An operating lease also allows your business to use the most current equipment available in the marketplace without being burdened by financial ownership.
Realize maximum tax benefits through an operating lease. The leased equipment involved in an operating lease can be treated as an operating expense, rather than a capitalized asset. This makes an operating lease the most tax friendly of the lease options.
What happens at the end of an operating lease?
When an operating lease terminates, the lessee has three options:
- The leased equipment may be returned to the lessor.
- The lease terms may be renewed and extended at a rate consistent with the fair market value of the equipment.
- The equipment may be purchased at its fair market value.
Capital leases allow you to own the leased assets for accounting purposes. However, the title to the equipment does not transfer over to your company until the lease terms expire. In a typical capital lease the lease term covers the equipment's entire useful life, as it is defined by MACRS accounting rules.
There are risks associated with capital leases. The total present value of capital lease payments is significantly greater than the total operating lease payments. Capital leases, because payments are greater than operating leases can also be a strain on short-term cash because the monthly payments are larger than for an operating lease.
In a capital lease, the lessee assumes the "residual value" risk on the equipment. So if the technology changes before the end of the lease, you will have less flexibility to upgrade or change equipment than with an operating lease. You would also be required to purchase any desired upgrades, even if the underlying equipment was obsolete.
Additionally, if the lessee were in an Alternative Minimum Tax (AMT) bracket, then the depreciation available through a capital lease would have no value. And, if the lessee has a Net Operating Losses carry forward, there would be no benefit to the depreciation.