Factoring 101

Introduction to Equipment Leasing

Introduction to Equipment Leasing

For many business owners, leasing is a primary part of the capital budgeting process and a popular  alternative to more traditional types of business financing for purchases of new equipment.  Additionally, refinancing existing equipment through the process of leasing also offers a viable method for restructuring and recapitalization, allowing companies to utilize their working capital more effectively.

Financially educated business owners recognize that utilizing the leasing alternative can improve their company’s balance sheet and help to preserve it’s borrowing capacity.  In addition to preserving such borrowing capacity, equipment leasing often provides the additional benefit of reducing a company’s tax liability, especially if the company uses a great deal of tax depreciation.

Introduction to Equipment Leasing

A lease is a contract in which one party (known as the lessor) gives another party (known as the lessee) the exclusive right to use its property or equipment for some specific length of time.  The lease contract may cover a single transaction or a continuing set of forward transactions set to occur over a period of time in which case a Master Lease Agreement may be executed, allowing for acquisitions of multiple pieces of equipment.  Whether formatted as a single transaction or a multiple financing arranged under a Master Lease, the contract will require the lessee to make scheduled periodic payments to the lessor for the use of the equipment and these payments will be made for a determined period of time.

The Two Main Primary Categories of Leases

There are significant differences in the various types of leases which are available including hybrids and combinations and such combining and modifying of lease structures can make identification even more confusing.  But for purposes of general explanation, it is best to categorize leases into two broad categories: 

  • finance leases (capital leases) and…
  • operating leases

Finance Leases (Capital Lease)

 Finance leases, often referred to as capital leases, are characterized by a long term commitment to purchase equipment in which the sum of the payments will be approximately the same as the total purchase price of the equipment.  Finance leases are attractive to businesses wanting the tax advantages of ownership and are typically created as 100% financing arrangements.  Finance leases are typically non-cancellable and must run their entire term. 

Since a capital lease will run for the equipment’s useful life, the lessee bears most of the risk of equipment obsolescence.  Capital leases are most often structured as triple net leases with the lessee being responsible for …

  • maintenance on the equipment
  • insurance covering the equipment
  • applicable taxes on the equipment

As mentioned, finance leases are often termed capital leases which must contain at least one of the following provisions:

  • an option to purchase the equipment at lease end at a “bargain” price (typically a $1.00 or 10%)
  • a transfer of ownership from the lessor to the lessee at the end of the lease.
  • a lease term equal to 75% or greater of the useful life of the equipment.
  • the present value (PV) of minimum lease rental payments is 90% or greater than the fair market value (FMV) of the leased asset minus investment tax credits retained by the lessor.

Operating Lease (True Lease)

Operating leases, also known as true tax leases, usually involve shorter terms of commitment and are attractive to businesses that do not want or need the depreciation tax benefits of equipment ownership and want to return the old equipment at lease end, avoiding repair or obsolescence.  This makes operating leases attractive methods of acquiring high-tech electronics equipment items such as computers which quickly become obsolete due to innovation and technical development.

Operating leases provide the lowest periodic payment of any financing alternative for equipment, which may subsequently be leased multiple times by the lessor, as it recovers its investment.  In operating lease structure, the lessee is allowed to expense the entire lease payment.  The lessor, however, is still the owner of the equipment for purposes of tax depreciation.   

All operating leases must meet certain IRS qualifying requirements.  In an operating lease:

  • the term of the lease must NOT exceed 80% of the useful life of the equipment.
  • the estimated residual value of the equipment (without adjustment for inflation) must approximately be equal to the fair market value of the equipment.
  • neither the lessee or any related party can have the right to purchase the equipment at less than its fair market value at conclusion of the lease or in other words, no bargain price.
  • neither the lessee or any related party can guarantee payment of any part of the purchase price of the
    leased equipment or in other words, the lessee may not invest in the equipment other than through the lease.  In other words, financing must be 100%.
  • the equipment subject to the lease must not be of the “limited use” types, so that no other party could use the equipment at lease end.