Leasing equipment can be an
attractive alternative to purchasing but you must do your homework. Many small businesses now lease various
kinds of equipment, such as cars, computers, office furniture, manufacturing machinery,
heavy equipment and other items.
Leasing may provide the small business with lower initial and monthly
costs, allowing the business to conserve its capital. If the term of the lease matches the equipment's useful life
(which it ordinarily should), you need not be concerned about having to dispose
of a no longer useful asset. Lease
payments, if ordinary, necessary and made in the course of your business,
should be deductible for income tax purposes.
In discussing and
negotiating leases, it is helpful to understand basic terminology often
used. The person or company that owns
the equipment and leases it is usually called the "lessor". The company that leases the equipment and
uses it in its business is usually called the "lessee". Following are some other commonly used terms
and their definitions:
Financial Lease: This is
the kind of lease most often used by a business to enable it to acquire equipment
that would otherwise be purchased. The
typical financial lease calls for periodic payments, usually monthly. The term of the lease approximates the
useful or economic life of the equipment and the equipment is returned to the
lessor at the end of the lease term.
The lease may not be cancelled by the lessee and the lessee usually must
maintain the equipment and repair it throughout the term. In short, the lessee enjoys most of the
benefits of ownership and also most of the obligations, but does not really own
the equipment.
Gross Lease: In this form of
lease the lessor is responsible for all expenses associated with ownership of
the equipment such as maintenance, taxes and insurance.
Net Lease: A net lease is
the opposite of a gross lease. Here,
the lessee is responsible for expenses related to the operation of the
equipment such as maintenance, taxes and insurance.
Leveraged Lease: In this
kind of lease, the lessor puts up part of the purchase price of the equipment
and borrows the rest from one or more banks or other lenders. The fact that a lease is a leveraged lease
should not affect the lessee.
Sale and Lease-back: The
sale and lease-back arrangement is similar to a financial lease. Here, the business that desires use of the
equipment purchases it, sells the equipment to a leasing company and
simultaneously leases it back from the leasing company for a specified
term. In this type of lease
arrangement, the lessor often provides the lessee an option to purchase the
equipment at the end of the term.
Closed-end Lease: This kind
of lease is common with automobiles.
Here, the lessor and lessee forecast the fair market value of the leased
equipment at the end of the term. The
periodic lease payments made by the lessee are based on the amount of the
equipment value that the lessee will "consume" over the term, that is
the original purchase price minus the forecasted fair market value at the end
of the term. If it turns out that the
leased equipment is worth less at the end of the term than the parties
predicted, the lessee must pay to the lessor the difference in value.
Open-end Lease: This lease
is the opposite of a closed-end lease.
Here, the lessee has no obligation to the lessor if the fair market
value of the equipment is less at the end of the term than predicted.
Residual Value: This is the
value of the equipment at the end of the term.
Capital Lease: This is a
lease of a piece of equipment or an item that, if purchased, would take a
substantial capital investment.
According to accounting rules, capital leases must be recorded on the
balance sheet of the business directly.
The economic value of the capital in the equipment is shown as an asset,
and the obligations under the lease are reflected as a liability.
Option to Purchase: In some
leases, the lessee is given the option to buy the equipment at the end of the
lease term, either for "fair market value" or for a set price. When negotiating a lease, inquire whether
the lessor will grant you an option to purchase. In some cases, a lessor may even grant an option to purchase at
the end of the term for some nominal amount, such as $1.00. While these provisions are enforceable
between the lessor and lessee, they are usually dangerous for the lessor. The risk arises if the lessee runs into
problems and cannot make the lease payments and meet other obligations. If another creditor attaches the leased equipment,
the court may rule that the lease arrangement is really a disguised sales
agreement. In that case, the lessor's
interest in the equipment is recast as that of a seller who financed the sale
of the equipment for the benefit of the lessee/buyer. In that position, the lessor/seller would
have only a security interest in the equipment and stands to lose it to other
creditors.