The “leasing vs. financing” question has a lot of layers, and I’ve explored a lot of them in this blog over the years (like “vehicle leasing vs. financing”, and the “differences between a capital lease and an operating lease”.) 

But one thing I haven’t talked about too much is the off-balance sheet aspect of an operating lease, and how it relates to board approval. And I had a situation crop up recently that perfectly exemplified this.

Many companies, especially larger entities, will utilize a board of directors that makes company decisions. Now let me start by saying a corporate structure requires a board, but in the case of many corporations, the “board” is a two person entity (husband and wife, business partners, relatives, etc.)

But in other companies, especially once the company is larger and more complex, there’s an actual board of directors. And this board of directors makes decisions. And one of those decisions may be acquiring new assets.

In other words, there are many companies who cannot acquire a new asset without board approval. Now this isn’t super-limiting – after all, most board members became board members because they are smart businesspeople, and if a company needs something, it needs something. 

But sometimes getting a timely meeting to approve a new asset can be troublesome, and if time is of the essence, this can be detrimental. 

In the example I’m giving, a company was in the middle of an important project. There was an unforeseen problem, and the company realized they needed another piece of equipment quickly. Getting a meeting together for board approval was going to take two weeks. That kind of time would have put the project hopelessly behind schedule, and also may have cost money, as another rate increase was imminent. What to do?

Lease it. Lease it with an Operating Lease. 

Operating leases are off-balance-sheet. The company doesn’t own the item, and it doesn’t appear as an asset. Most importantly, it then doesn’t need board approval if that’s how your company works. Two weeks turns into two hours. 

Mind you, I’m not advocating anything nefarious or “hiding” anything from the board. It’s more about making sure a rule (“board approval needed, and we’ll talk at next month’s meeting”) doesn’t get in the way of production.

Now do you understand why leasing is faster than the boardroom? 

The first point I want to make is the one overriding factor that any business needs to determine is their goals for a lease first, then they should choose a lease that best meets their needs.

There are really two “main-yet-different” goals for any lease: either you are leasing equipment to take advantage of the benefits of “ownership” (like Section 179), or you are leasing to “not own” the equipment, thus keeping the equipment off the balance sheet as an asset and instead listing the lease payments as an expense. 

First let’s take a look at how Tax Accounting (e.g., the IRS) views leasing. They will look at any lease one of two ways: a True Tax Lease (also called a True Lease), and a Non-Tax Lease. A True Lease means the lessee (the company using the equipment) is NOT the owner of the equipment. In a Non-Tax Lease, the lessee is considered the owner. 

So if you want to not own the equipment and keep it off the balance sheet as an asset and instead expense the lease payments, choose a True Lease. If you want to be considered the owner and take a Section 179 deduction, choose a Non-Tax Lease.

Now since this post is about leasing and taxes, I ought to stop right there, because that’s all you really need to know. But I’m a little OCD and want to finish, so let’s take a look at how Book Accounting views leasing.

Book Accounting leases are classified as either an Operating Lease or a Capital Lease. In an Operating Lease, the equipment is viewed as a rental – it’s neither an asset or a liability on the balance sheet. A Capital Lease is generally viewed as ownership.

These all seem similar, right? But “book accounting” and “tax accounting” don’t always see eye to eye on lease types. For example, a True Lease doesn’t always qualify as an Operating Lease, but an Operating Lease always qualifies as a True Lease.

I won’t go any further than that, because it’ll get into things that we all need to discuss with our CPA’s, not an equipment finance guru’s blog! And this is why I said earlier “pick your goal first, then pick a lease”, and we’ll get more into that next time. 

[As always, this is not intended to be tax advice – always consult your tax adviser for details specific to your situation.]

Today, we’ll look at the two major lease structures, and discuss the advantages of both:

Let’s start with a Capital Lease. A capital lease is where the company / lessee want the equipment to appear on the balance sheet as an asset, but also wants to spread out the payments. The equipment leased is considered part of the company’s assets (i.e., ”capital”, hence the name). In fact, on paper, the company gets to treat the equipment as if they own it in every way, including claiming depreciation.

At the end of a Capital Lease, there is usually a buyout that is well below market value (e.g., a $1 buyout, a 5% buyout, etc.) The company/lessee makes this last payment, and the equipment is officially theirs.

Obviously, a Capital Lease is used when a company is fairly certain they will want to keep the equipment at the end of the lease. You could almost say a Capital Lease is like a loan.

But what if the equipment is something they don’t want to keep? Or don’t want on their balance sheet? That’s where an Operating Lease comes in.

An Operating Lease is a lease where the company/lessee is essentially making payments on the portion of the equipment’s value they are going to use. In other words, the seller/lessor figures out a future value of the equipment based on the desired lease term (“assuming normal use, what will this equipment be worth in three / four / five years?”). In general terms, the lease payments are based on that future value minus the current selling price.

The advantages to a company here is the fact that they do not / will not own the equipment, but still get to use it now. And the lease payments are considered operating expenses on an income statement (hence the name), which is a tax advantage over slower depreciation. Plus, the equipment stays off the balance sheet (which many companies would prefer). You could almost say that in broad terms, an operating lease is like long-term renting.

At the end of an operating lease, the company/lessee can return the equipment, re-lease it, or buy it for a price to be agreed upon in the future at lease end. You see these types of leases on vehicles a lot.

There you have it – the two basic lease structures. We’ll get into the individual lease types in the future.