To Lease Or Not To Lease - That Is The Question
Written by CMG News Contributor, Doug Carleton
It isn't quite Hamlet Act III, Scene I --- "To be or not to be..." but the 2021 version about whether or not to lease something is critical today because it involves a business owner's cash. Equipment leasing allows a business to gain access to equipment (and many other assets) without actually buying it. Leases are available from many sources - manufacturers, dealers, banks, and alternative financing companies. Business owners make regular payments in exchange for the use of the equipment. However, there are two significant differences. A lease on a piece of equipment can allow an owner to upgrade a piece of equipment more frequently without having to sell it and purchase a new one. The other difference is the tax treatment of leases. The tax treatments on equipment leases affect your business's financial statements - both balance sheet and income statement. These financial statements will also come into play if seeking a loan.
The following is going to be a gross oversimplification in the description because leases can be complicated. The intent here is to give you a place to start. There are two types of leases classified by the Financial Accounting Standards Board (FASB) - the capital lease and the operating lease. Both are required bedtime reading for accountants.
Capital Lease
A capital lease is considered an asset on your balance sheet. A capital lease is viewed as a loan, and interest payments are expensed on the income statement. The capital leased asset shows on the balance sheet at a percentage of its price. The asset is not shown at full value to give the lessor some cushion if the lessee defaults on the lease and the lessor have to sell the asset. Advantages of a capital lease are:
Lessee is allowed to claim depreciation on the asset, which reduces taxable income and increases cash flow
Interest expense also reduces taxable income
Operating Lease
The operating lease is an expense that remains off of the balance sheet as there is no ownership transfer. An operating leased item is like renting. The lease payments are treated as operating expenses which affect the income statement. Advantages of an operating lease include:
Provides greater flexibility allowing a company to replace/upgrade equipment more often
No risk of obsolescence
Accounting for an operating lease is simpler
Lease payments are tax-deductible
The important message here is that you should talk to your accountant first if you consider leasing something. You may be thinking that one type would be best for your company when it may be the other. Let your accountant give you the alternatives and then make your decision.
This blog entry is a slightly edited excerpt from Doug Carleton's 'The Daily Life Of A Small Business Owner' series. Doug was a mentor with SCORE, Startup Virginia, and Lighthouse Labs, and has 25+ years of experience in small business finance including 12 years in SBA lending. To contact Doug directly, please email him at sbaloanspecialist@comcast.net.