In almost any business, there are two sets of books – Accounting and Tax.
One ("Book Accounting") is how the company views things (using GAAP, or Generally Accepted Accounting Principles). The other ("Tax Accounting") is how the IRS views things.
These two often come into play when leasing equipment; and it is important for a company to understand the differences in how each accounting method views equipment leases. To give a good starting example of why this is necessary, a True Lease (which is an IRS term) doesn't always qualify as an Operating Lease (which is an Accounting term), but an Operating Lease always qualifies as a True Lease.
Let's look at the types of equipment lease transactions each recognizes, and the qualifications of each:
Tax Accounting (IRS)
The IRS considers all leases to fall under one of two types:
• True Tax Lease (or "True Lease"): The lessor is the owner of the equipment (in regards to federal income tax purposes) and receives the tax benefits of ownership, including depreciation and tax credits. The lessee may claim the lease payment as an operating expense deduction. To give an accounting slant on this, what accounting calls a "Fair Market Value Lease" typically qualifies as a True Tax Lease.
• Non Tax Lease: In regards to tax purposes, this lease is treated as if it were a purchase or a loan. In other words, the lessee receives the same tax benefits as 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 today is a very attractive benefit.
How does the IRS determine which type of lease it is?
A lease is NOT considered a True Tax 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.)
Book Accounting (balance sheet and income statement)
Utilizing Financial Accounting Standards Board (FASB) rules, leases are classified as either a Capital Lease or Operating Lease for financial reporting purposes.
• Operating Lease: This type of equipment lease is generally viewed as a rental. The leased equipment is not shown as an asset on the company's balance sheet. This is always viewed as a "true lease" by the IRS, and the company (the lessee) cannot take the tax benefits of ownership. It is important to note that sometimes, the term "FMV Lease" (Fair Market Value Lease) may be used interchangeably with Operating Lease.
• Capital Lease: This type of equipment lease is treated like a purchase. The leased equipment is shown as an asset and corresponding liability on the lessee's balance sheet, and the tax benefits of ownership may be realized, including Section 179 deductions.
How does FASB determine which type of lease it is?
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.
How to use this information
Besides explaining the different types of leases, Crest Capital also feels it is important to show you how they are generally used by businesses. Listed below are the objectives that many businesses look for in regards to equipment leasing, and how the various equipment lease types meet them.
Most small businesses want to minimize income taxes – therefore small businesses normally focus on Tax Accounting:
• True Lease - True Leases allow the business to "expense" each monthly payment immediately, rather than account for the equipment as an asset and depreciate it over 5 years. Additionally, the monthly payment on a True Lease is lower than a Non Tax Lease, which preserves cash flow.
• Non Tax 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 Non Tax 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.)
Most large businesses are more concerned with posturing Balance Sheets &Income Statements. Therefore large businesses normally focus on Book Accounting:
• Operating Lease - Allows the business to avoid accounting for the equipment as an asset, and also allows controllers more flexibility in matching the timing of expense with benefit. It also allows equipment to be kept as an operating expense (which often doesn't need board approval) and not a capital expenditure (which often does.)
• Capital Lease - Allows the business to bulk up the Balance Sheet by accounting for the equipment as an asset while, often times, not violating restrictions on adding new conventional debt that many lenders impose on businesses. The Capital Lease agreement also provides for a bargain purchase at the end of term, allowing the business to own the equipment (which they can continue to use, or even sell if they wish.)
If you have any further questions regarding which lease is right for your business, please contact us at Crest Capital, and we'll be happy to assist you.
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