Tax and Financial Planning . . . ALERT

The information contained in this ALERT is not intended to constitute legal, or financial advice.  Decisions with regard to these matters should only be made after consultation with a competent professional.

If you are in business, it probably involves the use of some sort of equipment. Even a door-to-door-salesman working for himself has to have an automobile. For most people, when a business item is needed, the first impulse is to buy it. Is that the proper decision, or should items be leased?

Changes in the Internal Revenue Code have revamped the tax treatment of many items and has made buying equipment more attractive than it once was. Basically, most companies can expense (that means deduct in one year) up to an inflation adjusted amount of $102,000 worth of equipment, and other items may qualify for 50% bonus depreciation treatment. Additionally, purchasing equipment on an installment basis is increasingly affordable with interest rates at historic lows. Although buying equipment has more appeal today than ever, there are times when leasing makes more sense for tax AND financial reasons.

First of all, if your business cannot fully take advantage of the tax benefits flowing from equipment ownership, leasing may be the better choice. Business equipment is often obtained through a so-called fair market lease, sometimes called a true lease. In this type of arrangement, your company has the option to return the equipment at the end of the term with no further obligation. Or, the lease may be renewed. Or, the equipment may be purchased at fair market value – hence the name. The big tax advantage to a business lease on most assets is that the lease payments are fully deductible as a business expense. This point contrasts with ownership of business assets which have to be written off over several years. Accordingly, leasing may accelerate tax deductions as compared with lengthy depreciation schedules that spread cost recovery over many years. Another advantage favoring leasing is the Alternative Minimum Tax (AMT). Under the AMT, depreciation deductions may be limited; but equipment leasing expenses are not items of preference under the AMT, so lease obligations cannot increase your AMT liability.

Aside from these tax considerations, there may be other compelling reasons to lease rather than to buy:

Preservation of Capital. When business equipment is purchased, typically a down payment is required. Equipment leases typically require little (if any) upfront cash. Also, “soft costs,” such as warranties, shipping and installation charges are usually built in to the lease cost rather than requiring immediate upfront payment.

Expected Obsolescence. If there is a substantial risk the equipment will be “out of date” before the end of its useful life, it may not make sense to buy it. If the equipment is leased, you can decide whether to keep it or upgrade to newer generation equipment. Also, regular replacement can reduce repair and maintenance costs

Limited Use. If your company only expects to need the equipment for a short period, why buy it?

Questionable Resale Value. If you buy an asset, you assume the risk of finding a buyer when the asset is no longer of value to you. This risk can be completely avoided by leasing rather than buying.

Urgency. If you need an item right away, working with a leasing company is probably indicated. And for inexpensive items, you probably will not have to provide financial statements, thereby greatly expediting the acquisition process.

What the decision frequently comes down to is that it typically does not make sense to buy depreciating assets, or those assets likely to become outdated soon. For such assets, leasing can usually provide 100% financing with payments spread to meet the cash flow and seasonal requirements of your business.

When the asset in question is an automobile (recall we initiated this ALERT with reference to a door-to-door salesman), there are other considerations mandated by the leasing companies AND the Internal Revenue Code. When applying the above factors, one would think an automobile should never be purchased as it meets the big tests of, preservation of capital; expected obsolescence; and questionable resale value. Leasing automobiles would probably always be the correct choice, except for:

Lease Limitations. Although just about anything is negotiable, automobile leases come in certain packaged formats, through which the use of the vehicle is severely limited. The norm in automobile leases today is 15,000 miles per year, but even 12,000 miles per year is not uncommon. If your use of the vehicle is going to be much higher than these mileage amounts, you are practically speaking, prohibited from leasing because the lease’s “excess mileage” charges will kill you and make the total cost of the lease very uneconomical. So, if the automobile is to be driven a lot, leasing may not be an option.

Internal Revenue Code Limitations. The Code requires an allocation between business usage of an automobile and personal usage. If our door-to-door salesman uses the car for personal matters on weekends, that usage must be separated out for deduction purposes. Whereas the full amount of lease payments on business assets is usually deductible, there are special rules for automobile leases.

Those special automobile considerations provide a nice transition into stating that leasing business equipment is not for everyone. As mentioned, the low interest rate environment favors purchases. Of course, any asset that you feel will increase in value should be purchased.

Some of the tax advantages of buying equipment include:

Expensing. As mentioned, up to an inflation adjusted amount of $102,000 in equipment purchases can be written off immediately. If equipment purchases are below that level, buying will usually be superior to leasing. A further motivation is that the expensing allowance is available when the equipment is put into service – not when it is purchased. Beware there is the practical limitation that your company must have some taxable income against which the expense allowance can be used to offset. Without that, the expense allowance provides no tax benefit!

Bonus Depreciation. In short, with 50% bonus depreciation, 50% of the dollar amount over the expense allowance can be deducted in the first year the equipment is put into service. A huge caveat is that Congress is always adjusting depreciation rules, and given we are into a new year, check to make sure what rules are in effect for any business purchases you might be contemplating in a particular year.

In summary, while certain provisions of the Internal Revenue Code will have an impact on any business “buy or lease” decision, other important factors can tip the scales. I conclude most of these ALERTS with some variation of the following: important financial and legal matters should be reviewed with a competent professional. Please ensure you expend the time and effort necessary to avoid making costly mistakes.

The hiring of a lawyer is an important decision that should not be based solely upon advertising. Please visit the Doherty Professional Association at www.dohertypa.com today to learn about Mr. Doherty’s credentials and how he might assist you in estate and financial matters.