Book Accounting, Tax Accounting, and Equipment Leasing Simplified

Chris Fletcher - Account Executive, Crest Capital - 02/10/2021

Book Accounting, Tax Accounting, and Leasing SimplifiedHow does Equipment Leasing fit into tax and accounting principles? Let’s find out.

When it comes to acquiring equipment, leasing can be an incredibly useful business tool for companies of any size.

Key among the benefits of Equipment Leasing is the flexibility it allows: if you wish to lease equipment but still claim a Section 179 deduction or use other tax advantages of “ownership”, there’s a lease for you. Conversely, if you wish to keep the equipment off your balance sheet and expense the payments, there’s a lease for you too.

1. "Book Accounting" utilizing Generally Accepted Accounting Principles (GAAP) which are promulgated by the Financial Accounting Standards Board (FASB). "Book Accounting" provides business owners and other stakeholders (such as lenders) with accurate and conformant financial data to understand how well the business is actually doing.

2. "Tax Accounting" utilizing the Internal Revenue Code (IRC) which are promulgated by the Internal Revenue Service (IRS). "Tax Accounting" provides the IRS and other taxing authorities (such as States) with taxable income and deductible expenses to determine how much tax to collect from the business.

So now that we know there are two types of accounting, let’s look at how each views leasing, starting with our friends at the IRS:

How Does the IRS (Tax Accounting) View Leasing?

The IRS rules regarding leases is pretty straightforward: they consider all leases to fall under one of two types: a True Tax Lease (or “True Lease”), and a Non-Tax Lease.

What is the Difference Between a True Lease and a Non-Tax Lease?

On a True Lease, the lessor (the entity receiving the lease payments) is the owner of the equipment and receives the tax benefits of ownership, including depreciation and tax credits.

On a Non-Tax Lease, the lessee (the entity using the equipment and making the lease payments) receives the tax benefits of ownership, including claiming depreciation and interest expense deductions (but not the lease payment itself.) A Non-Tax Lease can take advantage of Section 179, which is a very attractive benefit.

How Does the IRS Determine the Difference Between a True Lease and a Non-Tax Lease?

A lease is NOT considered a True Lease by the IRS if ANY of the following are true:

  • Any part of the lease payment is applied to an equity position in the asset leased.

  • The lessee will, by default, acquire ownership (title) of the equipment upon payment of a specified amount of "rental payments" he or she makes.

  • Over a short period of time the equipment is used, the total amount which a lessee pays is an exceedingly large proportion of the total sum required to outright buy the equipment.

  • The agreed upon payments exceed the current fair rental value.

  • At the time any purchase option may be exercised, the title to the equipment may be acquired for an exceedingly small purchase option price in relation to the actual value of the equipment.

  • Any portion of the lease payments are specifically designated as interest (or its equivalent.)

How Does Book Accounting / GAAP View Leasing?

Utilizing Financial Accounting Standards Board (FASB) rules, Book Accounting / GAAP leases are classified as either an Operating Lease or a Capital Lease for financial reporting purposes.

What is the Difference Between an Operating Lease and a Capital Lease?

An Operating Lease is generally viewed as a rental. The leased equipment is neither shown as a liability nor an asset on the lessee’s (company making the lease payments) balance sheet, and the lessee cannot take advantage of depreciation and similar. It is important to note that sometimes the term “FMV Lease” (Fair Market Value Lease) may be used interchangeably with Operating Lease.

A Capital Lease is treated like a purchase for tax and depreciation purposes. The leased equipment is shown as an asset and/or a liability on the lessee's balance sheet, and the tax benefits of ownership may be realized, including Section 179 deductions.

How Does the FASB Determine the Difference Between an Operating Lease and a Capital Lease?

A lease is NOT considered an Operating Lease by the FASB if ANY of the following are true:

  • Ownership of the leased equipment automatically transfers to the lessee by or at the end of the lease term.

  • The lease contains a bargain purchase option for the equipment.

  • The term of the lease is equal to (or greater than) 75% of the anticipated economic life of the leased equipment.

  • The present value of the minimum lease payments - at the beginning of the lease term - is equal to or greater than 90% of the original fair market value of the equipment.

Now that we’ve explained the different ways accounting principles look at equipment leasing, let’s answer a few common questions:

Is a True Lease and an Operating Lease the Same Thing?

Usually, but not always. A True Lease (an IRS term) doesn’t always qualify as an Operating Lease (an Accounting term), but an Operating Lease always qualifies as a True Lease.

What Are the Tax Benefits of Leasing?

Most small businesses want to minimize income taxes – therefore small businesses will typically focus on tax issues when looking at leasing, using a Non-Tax Lease / Capital Lease

The main benefit in this type of lease involves Section 179. This means the entire cost of the equipment can usually be written off the year it is purchased and put into use. The Lease agreement also provides for a bargain purchase at the end of term, allowing the business to own the equipment after the lease is up (and reap the benefits of such by either continuing to use it, or perhaps even sell it.)

What Are the Balance Sheet Benefits of Leasing?

Most large businesses are more concerned with Balance Sheets & Income Statements and will generally look for a True Lease / Operating Lease.

The main benefit here is this allows the business to avoid listing the equipment as an asset and allows more flexibility in matching the timing of expense with benefit. It also allows the equipment payments to be kept as an operating expense (which often doesn’t need board approval) and not a capital expenditure (which often does.)

Looking to Properly Structure an Equipment Lease:

If you're adding equipment and need the lease structure that's right for your business, we have several options for you. Here are the different lease types Crest Capital offers (note: We offer leases that satisfy both types of accounting principles – if you need a lease for tax and Section 179 benefits, we have several good options. If you need the equipment off the balance sheet, we offer Operating Leases as well.)

You can check your eligibility quickly and easily here. It takes two minutes, and can give you a good idea whether you’ll qualify for an equipment lease.

the Lease Guy

About the Author
Written by (aka the Lease Guy). Chris is a senior account executive at Crest Capital, where he manages vendor finance programs for manufacturers and dealers of equipment, vehicles, and software. He's also an active Twitterer—check out his page if you follow financial topics and current events in the world of finance.

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