The Basics of Leasing

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.