There is a myth amongst many businesses, bankers, and credit analysts today that leasing is reserved for those companies who are unable to obtain traditional loan financing. This myth is absolutely not true. On the contrary, leasing is generally utilized by most companies because it offers the following benefits:
- Equipment Obsolescence Hedge
- Flexibility for Equipment, Takeout, Rollovers, and Upgrades
- Affordability To Company
- Circumvention of Capital Budget Constraints
- Reciprocity of Tax Benefits
- Deductibility of Lease Rental Payments
- Use Versus Ownership
- Less Restrictive Form of Financing
- Lessee’s Potential for Ownership at Lease End
- Diversification of Financing Sources
- Additional Source of Debt Financing
The main reason why equipment leasing continues to grow is that leasing meets the needs of so many types and sizes of companies. Mature profitable companies may lease equipment to keep bank credit lines open for other purposes. Young, start-up companies lease primarily to conserve cash, while businesses requiring state of the art technology lease equipment to avoid technological obsolescence and to preserve the ability to upgrade. Again, the needs of each company are different and leasing can meet those needs.
The information below covers some of the common reasons why companies lease and the benefits it may receive by utilizing this growing form of financing.
Equipment Obsolescence Hedge
Perhaps one of the strongest reasons for acquiring equipment through leasing, as opposed to purchasing, is that leasing helps lessees avoid the risk of ownership. A key risk of ownership is that of the equipment obsolescence. Much of today’s equipment is based upon technology that is rapidly changing, thus making the equipment subject to obsolescence. The inherent risk of owning technologically-sensitive equipment is that the equipment may become economically useless for the company owning it much earlier than expected and long before the obligations to acquire the equipment have been satisfied. Leasing can shift the ownership risk from the lessee to the lessor.
Takeout, Rollovers, and Upgrades
These common lease options give the lessee flexibility during the lease term should the leased equipment become obsolete prior to the termination of the lease. A takeout occurs when a lessor replaces the obsolete equipment with updated equipment, whereby the lessee is "taken out" of the outmoded equipment and then leases the updated equipment. Sometimes a lessee may only need an upgrade of its current equipment as opposed to complete replacement. Many lease contracts today are written with upgrade provisions that allow additional equipment to be added to the existing system.
Affordability to Company
The acquisition of assets through leasing, as opposed to purchasing, becomes even more desirable as the cost of the equipment rises. There are a number of reasons for this. First, as a general rule, leasing companies require lower down payments than other financial institutions. A typical lease requires one, or possibly two, lease rentals paid in advance as opposed to the traditional 10-20% down payment for a loan. Second, other incidental costs of acquiring the asset, such as sales tax and installation charges, can be included as part of the lease payment itself, rather than being paid in advance with a large down payment. Finally, many businesses mistakenly use funds for short-term working capital needs to purchase long-lived assets, thereby hindering its day to day operations. Leasing helps a company to conserve its working capital for its intended purpose.
Circumvention of Capital Budget Constraints
Many profitable companies choose to lease for one very real reason - to circumvent various budget capital constraints. A company may have sufficient funds to purchase a new piece of equipment outright. However, if the company has already fully utilized it budgeted amount for capital expenditures, it most likely will be precluded from purchasing the equipment. The company could lease the necessary equipment and pay for the lease rentals out of its operating budget instead of the capital budget. By utilizing leasing, the company obtains the equipment it needs and avoids the capital budget scrutiny that may not have worked in its favor.
Income Tax Motivations
Reciprocity of Tax Benefits
When leases are structured such that they qualify as tax leases per IRS criteria the lessor will be considered the tax owner of the equipment and, as such, receive certain tax benefits in the transactions, most notably depreciation. As a result of these benefits, lessors in a higher tax bracket experience meaningful tax savings that they in turn may fully or partially pass on to the lessee in the form of a reduced lease rental payment. Consequently, the lessee can indirectly share in the lessor’s tax benefits.
Deductibility of Lease Rental Payments
Lease payments in a tax lease are fully deductible for federal income tax purposes. This deductibility of lease payments provides a clear tax benefit for the company. In regard to this deductibility of lease payments, leases (particularly short-term leases) provide an even greater tax incentive for the company. If a company were to purchase the equipment, utilizing loan financing, it would only be able to deduct depreciation expense and any related interest expense.
Use Versus Ownership
For years, many companies have realized the use of a piece of equipment is far more important to the production of income than a piece of paper conveying title to the equipment, as it is the use of the equipment that produces profit, not ownership. In fact, if equipment can be used for most of its economic life without the user having the full legal responsibilities, risks and burdens of ownership, then little value exists in the actual ownership of the equipment.
Less Restrictive Form of Financing
When lending to a company, banks typically impose restrictive loan covenants into the loan agreement. The covenants are used by the bank to help minimize, or at least to bring to its attention, any potential default on the loan by the borrower. Loan covenants, while attempting to minimize the lender’s risk, oftentimes can be very restrictive. Lease agreements rarely contain restrictive covenants, thereby offering greater freedom and flexibility than a loan.
Lessee’s Potential for Ownership at Lease End
An important aspect of leasing that has influenced its popularity is that the lessee generally has the ability to purchase the equipment at the end of the lease term and, thus, may eventually become the owner of the equipment. Some purchase options are set at prestated amounts while many leases state the purchase option amount is equal to the equipment’s established fair market value. Structured correctly, fixed purchase option leases can provide the benefit of leasing with the ability of purchase/ownership at the end of the lease.
Diversification of Financing Sources
Many businesses are aware of the danger of depending solely upon conventional sources of equipment financing. Diversification of financing sources makes good sense whether credit is in short supply or not.
Additional Source of Debt Financing
Most businesses maintain revolving lines of credit as well as other credit lines with its primary banking relationship. These lines are usually limited to a maximum dollar amount which may be borrowed. The company, by utilizing lease financing for its asset needs, will then be able to keep its primary credit lines available for other financing needs the business may have during the year.
Leasing provides a company with greater flexibility. Leasing companies have and continue to find ways to structure lease transactions to fit the needs of customers. This gives the company the opportunity to make the most of lease structuring variables such as, number of payments, amount of the advance payment, purchase options, interim rent, etc. Most lease arrangements allow customers the option to either purchase at a stated amount or the Fair Market Value, or to renew the lease at a reduced monthly payment. The lease structure determines which of these options is available.
In summary, the reasons for the growing popularity of leasing have been briefly summarized above. As noted, it can be seen that companies lease for a variety of reasons. At times, a company leases to avoid the risks of technological obsolescence, to benefit from the off balance sheet operating leases or to take advantage of the many flexible structuring options available in the lease. The benefits of leasing to a lessee are numerous and just one of the reasons mentioned above may motivate a company to lease rather than to purchase.
Kinetic Leasing offers a wide variety of leasing products, providing you with the flexibility to meet the needs of your business:
- Finance or Capital Lease
- True or Tax Lease
- Operating Lease
- Municipal Lease
- Lease Line of Credit
The following is a description of each of the lease products:
Finance or Capital Lease
This lease is referred to as a non-tax lease, whereby, the lessee can acquire use of an asset for most or its useful life. From a financial reporting perspective, this lease has the characteristics of a purchase agreement, with the underlying equipment shown as an asset and the accompanying lease depicted as a liability on the lessee's balance sheet. The lessee then expenses the depreciation and interest associated with the lease on its income statement.
- Up to 100% financing
- Lessor does not select manufacturer or supply equipment
- Various purchase options - commonly $1.00 or 10%–15% of equipment cost
- Similar to purchase agreement - utilizing loan financing
True or Tax Lease
A true or tax lease is a transaction which qualifies as a lease under the Internal Revenue Code such that the lessor takes on the risks of ownership and the lessee is allowed to claim the entire amount of the lease rental payment as a tax deduction. Under this type of lease, the lessor claims the tax benefits of ownership including depreciation.
- 100% financing
- Fair market value purchase option
- Low lease rental payments
- Off balance sheet financing for lessee
A short term lease whereby, the lessee can acquire the use of an asset for a fraction of the useful life of the asset. Typically, in this lease type, the lessor has taken a significant residual position in the lease pricing and, as a result, must salvage the equipment for a certain value at the end of the lease term in order to earn its desired rate of return on the transaction. All operating leases are considered tax leases, as a result, the lessor is the owner of the equipment underlying the lease and the lessee is entitled to claim the entire amount of the lease rental payment as a tax deduction.
- Short term
- Typically involves a residual position funded by the lessor.
- Off balance sheet financing for lessee
This lease is basically a conditional sales contract disguised in the form of a lease which is only available to municipalities. Under this lease type, the interest earnings on the lease are tax-exempt to the lessor and the lender purchasing/discounting the lease. It is noted that a municipal lease would never be considered a true or tax lease, as this lease must be structured with a $1.00 buyout at the end of the base lease term.
- 100% financing
- $1.00 buyout only
- Reserved only for municipalities including but not limited to:
- Park Districts
- County/City owned hospitals and clinics
- School Districts
- Fire Departments
Commonly asked questions regarding municipal leases
Lease Line of Credit
Pre-approved credit line which allows the lessor to purchase equipment on the lessee's behalf until such time as all equipment which is intended to be placed on lease has been delivered and installed. This product accommodates equipment installations which occur over an extended period of time, and does not require the lessee to secure interim financing with another lender, or tie up its existing lines of credit.