Types of Business Leases

In the current economic and tax environment, leasing may offer important financial benefits to companies when compared to commercial loans. The specific benefits depend on the type of lease chosen. There are two primary types of commercial leases.

• Capital lease: Here both the asset and the corresponding debt are carried on the lessee’s balance sheet. As a result, the lessee retains all of the tax benefits, taking deductions for depreciation expense and the interest portion of the lease payment. At the expiration of the lease term, the equipment’s title is transferred to the lessee, or there’s an option for the lessee to purchase the equipment for a minimal amount (such as one dollar).
• Operating lease: Here the lessor retains ownership of the asset or equipment. At the end of the lease term, the lessee will have the option of returning the equipment to the lessor or purchasing it at fair market value. The tax benefits, including asset depreciation and any allowable tax credits, are retained by the lessor but may be passed to the lessee in the form of lower lease payments.

  
  

  
  Because operating lease payments are treated as an operating expense on the lessee’s income statement, the lease does not affect the company’s balance sheet. This type of lease is often referred to as off-balance-sheet financing.

  
  

The Benefits of an Operating Lease

The off-balance-sheet nature of an operating lease is one of the biggest draws of this type of financing. This is especially true when compared to on-balance-sheet alternatives like commercial loans, in which a company will leverage an asset (such as accounts receivable) in order to borrow money, thus creating a liability (i.e., the outstanding loan) that must be reported on the balance sheet.

With an operating lease, however, liabilities do not have to be reported, because no debt or equity is created. This optimizes a company’s financial leverage and makes its balance sheet more attractive to potential lenders.

Off-balance-sheet financing creates liquidity for a business while avoiding leverage, thus improving the overall financial picture of the company. This can help companies keep their debt-to-equity and other leverage ratios low, which is especially important if the inclusion of a large capital expenditure on the balance sheet might violate debt covenants that apply to an existing bank loan.

Strict accounting rules must be followed when it comes to properly distinguishing between on-balance-sheet and off-balance-sheet financing. To help companies make the right determination, the Financial Accounting Standards Board has created guidelines stating that a lease must be treated as a capital lease if it meets any one of four conditions.

1. The life of the lease life exceeds 75 percent of the life of the asset.
2. There is a transfer of ownership to the lessee at the end of the lease term.
3. There is an option to purchase the asset for a minimal amount at the end of the lease term.
4. The present value of the lease payments, discounted at an appropriate discount rate, exceeds 90 percent of the fair market value of the asset.

Because the accounting and tax ramifications of equipment leasing can be complex, you should work closely with a financial and/or accounting professional as you determine financing options for your company.

Read the next article in Don Sadler’s leasing series, “Should You Buy or Lease Your Business Facility?”.

Don Sadler is a freelance writer specializing in business and finance. Reach him at don@donsadlerwriter.com.