Equipment Leasing: Introduction to Leasing

A lease is a contract in which a customer (lessee) pays a monthly, quarterly, semi-annual or annual rent to an owner (lessor) for the right to use equipment (airplane, computer, barge) for a specific amount of time (i.e. 60 months.

Although leasing began in 2010 B.C.,modern leasing began in the early fifties. The creation of the Investment Tax Credit in 1962 spurred additional growth through "tax-oriented" leasing. New products were quickly developed to meet the growing demand. Over the last 50 years, many leasing companies developed non-tax oriented products such as income funds, operating leases, limited partnerships, vendor programs, and residual sharings in order to remain competitive.

Equipment leasing blossomed over the last 20 years due to:

The banking industry entered the picture, giving credibility to a marketplace which had been previously regarded as a last-resort financing alternative.

The accounting profession produced a document (FASB 13) to help standardize lease reporting in financial statements.

The Internal Revenue Service issued guidelines (Rev Ruling 55-540 and Rev Proc 75-21) to aid lessors and lessees in structuring leasing transactions.

Why do businesses lease:

Cash flow - monthly payments are generally smaller for leases than for loans and they usually require a smaller or no downpayment.

Use vs. ownership - many businesses have discovered they don't need to own the equipment they use. In the past renting and leasing were frowned upon. Today's psychology looks more to the economics rather than the moralities of ownership.

Tax benefits - Depreciation and interest on debt produce potential tax benefits.

Better-looking financial statements - certain leases provide the user with "off-balance sheet" accounting treatment.

Leasing is governed by the Financial Accounting Standards Board (FASB), and the Internal Revenue Service (IRS) and the Uniform Commercial Code (UCC).

Please see various articles on FASB, IRS and the UCC

Confusion arises when these regulatory bodies do not agree. Since lease contracts are fairly complicated, regulatory bodies must decide whether the language of the contract governs the transaction or whether the intention of the parties should be followed.

The following highlights the major differences between FASB and IRS. Basically, ownership interest is transferred to the lessee when:

FASB


explicit transfer of ownership

bargain purchase option exists

term of lease is at least 75% of equipment's economic useful life

present value of payments is at 90% of the equipment's fair market value



IRS


explicit transfer of ownership

bargain purchase option exists

lessor makes less than 20% "at risk" investment in the asset

payments significantly higher than fair rental value

part of the rent can be construed as a recovery or principal or interest



Ownership interest remains with the lessor only if none of these criteria are met. Because the criteria differ somewhat, ownership interest may transfer to the lessee according to one authority and remain with the lessor according to the other.

As far as state and local taxing authorities are concerned, ownership resides with the lessor unless title has been explicitly transferred. This usually makes the lessor responsible for remitting sales and personal property taxes as well as billing the lessee.

In general, there are two major lease types, capital leases and operating leases. Until 1986, both types of leases were very popular leasing products for the equipment leasing industry. However, the 1986 Tax Reform Act, which strongly deemphasized federal tax benefits and lowered corporate tax rates, discouraged the use of capital leases and encouraged the use of operating leases.

A capital lease typically transfers ownership of the equipment from the lessor to the lessee at the end of the lease. Whereas, in an operating lease the lessee returns the equipment to the lessor at the end of the lease without any further obligation.




Tax-oriented leases - Lessors receive tax benefits provided by the federal government. Examples include accelerated depreciation, and tax credits. These types of leases are not as attractive today since they no longer carry the tax benefit of the Investment Tax Credit.

Full-payout leases - transactions in which the total payments other than the residual cover the lessor's total equipment cost. This type of lease would normally be a capital lease for accounting purposes, but could be structured either way for taxes.

Operating leases - used for short-term equipment rental. An example would be an equipment manufacturer who creates a specific rental market, such as specialty railcars and oil tankers. These leases have become very popular with most companies looking for income rather than tax savings.

Leveraged leases - complex financial arrangements in which a third-party lends money to the lessor who puts in some equity to buy an expensive piece of equipment, such as a jumbo jet. The lender bases his credit decision on the creditworthiness of the lessee and makes the loan to the lessor on a non-recourse basis. The lessor keeps all the tax benefits and uses the leverage to create a high return on investment.

Sales-type leases - this term is defined by FASB 13 for manufacturers who build equipment and then lease it to their customers. These leases are structured like direct financing or capital leases for accounting purposes. This type of lease has also been effected due to the restriction of instalment sale accounting and the disproportionate allowance rule. Nonetheless, captive finance companies use this type of structure frequently to help finance parent's products and customers.