Buy or lease?

By Mark E. Battersby| June 8, 2015

New rules will have an impact on whether it’s better to buy or lease equipment for your operation.

Even as credit becomes more readily available, whether to buy or lease is a question facing many crushed stone, sand and gravel producers and businesses. While there is no one correct answer that fits every situation, nor every aggregates business, compared to the simplicity of buying, leasing is far more complicated and may be getting more complex.

The lease accounting rules as we currently know them may be changing as a result of ongoing negotiations between the International Accounting Standards Board, which sets rules for many countries around the globe, and the U.S. Financial Accounting Standards Board, which writes the rules in the United States. The proposals would require many businesses to add all but the shortest leases to their balance sheets as liabilities, much like debt.

Why lease?

Equipment leasing is similar to a loan in which the lender buys and owns equipment and then “rents” it to an aggregates producer at a flat monthly rate for a specified number of months. Although lease financing is generally more expensive than bank financing, in most instances it is more easily obtained.

Among the reasons given by small business owners for leasing are the ability to have the latest equipment, consistent expenses for budgeting purposes, help in managing their operation’s growth, no down payment and the fact that leasing doesn’t adversely impact the financial statements.

Leasing offers real advantages, including reduced cash outflows and greater control. But that’s not all. Here is a short list of leasing advantages:

■ Conventional bank loans usually require more money upfront than leasing.

■ Leasing generally requires only one or two payments upfront in lieu of the substantial down payments often required to purchase equipment.

■ Unlike some financing options, leasing offers 100 percent financing. That means an aggregates business can acquire essential equipment and begin using it immediately to generate revenues with no money down.

■ The full amount of the equipment, as well as service or maintenance, can be included in the lease. This spreads the cost over the term of the lease, freeing up cash flow for the aggregates operation now, when needed.

■ Leasing provides a hedge against technology obsolescence by allowing a business to upgrade its equipment at the end of the leasing term.

■ At least for the time being, an operating lease is not considered long-term debt or liability and does not have to show up on the business’ financial statements. This makes the business more appealing to traditional lenders down the road or when needed.

■ Although operating lease payments are generally treated as fully deductible business expenses, a tax professional should be consulted to determine what percentage of other lease types are deductible.

Buying equipment

Ownership and tax breaks make buying business equipment appealing, but high initial purchasing costs can mean this option isn’t for everyone. Among the advantages of buying equipment is, of course, ownership. In other words, the most obvious advantage of buying business equipment is that the aggregates operation owns it. This is especially true with property that has a long useful life and is not likely to become technologically outdated in the near future, such as office furniture or mining machinery. The disadvantages of buying equipment are:

■ Higher initial expenses. For some quarry operators, purchasing needed equipment may not be an option because the initial cash outlay is too high. Even if the operation plans to borrow the money and make monthly payments, most banks require a down payment of around 20 percent. Borrowing money may also tie up lines of credit, and lenders may place restrictions on the aggregates business’ future financial operations to ensure the loan is repaid.

■ Obsolete equipment. While ownership is perhaps the biggest advantage to buying equipment, it can also be a tremendous disadvantage. Purchasers of high-tech equipment run the risk that the equipment may become technologically obsolete, and they may be forced to reinvest in new equipment long before planned. Certain types of equipment have very little resale value.

Tax strategies

In the eyes of the IRS, whether a leasing transaction is treated as a lease or as a purchase determines who will be entitled to deductions for expenses such as depreciation, rent and interest expenses.

Generally, when it comes to determining who owns the property for tax purposes and, thus, who is entitled to the depreciation deductions, the IRS looks to the economic substance of the transaction – how it is structured and works; not how the parties involved characterize it.

Lease or rental payments are, of course, usually fully deductible. With a purchase, Section 179 of the Internal Revenue Code allowed sand, gravel or crushed stone businesses to fully deduct the cost of some newly purchased assets in 2014. Section 179 of the tax law allowed a business to deduct the entire cost of up to $500,000 of new or used equipment and other depreciable assets with less than a 20-year life. With 50 percent bonus depreciation, an aggregates producer could deduct half the cost of new capital purchases in the first year.

Fortunately, there are no time limits on leasing. That means leasing can be effective where an aggregates business has already purchased equipment. These transactions, known as sale-leasebacks, are usually available for equipment purchased within the past 90 days. Sale-leasebacks may also be used to legitimately shift the tax benefits from the sand, gravel or crushed stone operation or business to its new owner or owners.

Equipment or property that is already on the operation’s books can be sold to the owner or shareholder – or to key employees – and leased back to the business. Because these self-rental transactions involve shifting tax benefits from the business to its owners or shareholders, they should be “arm’s length” transactions and the parties should be aware of possible IRS scrutiny.

Changes in the wind

As proposed, the new rules would represent a major change in how most businesses account for the cost of leases by requiring vastly larger amounts of assets and liabilities to be reported on an operation’s books. Under current rules, an aggregates producer is generally able to classify many leases as “operating leases” and keep them off their balance sheets.

This so-called “off-balance-sheet financing” can make a business look less indebted than it really is. The proposed lease accounting rules will require many businesses to add to their balance sheets all but the shortest leases, as liabilities akin to debt.

The proposal would also set up a two-track system for how lease costs should be reflected in the operations’ earnings. Costs of real-estate leases would be recognized evenly over the term of the lease, while costs of other leases would be more front-loaded and would decline over the lease term.

Should these accounting standards be adopted as proposed, it is the banks and other lending institutions that would be impacted first and hardest. With lenders forced to increase their capital and new restrictions on the sources of funds those institutions rely on, leasing might become a tighter market and far more expensive.

In all likelihood, there will be a considerable delay in making the new rules effective, probably until 2017. This would give aggregates producers and businesses time to comply and, in some cases, to renegotiate loan agreements. The many businesses that currently have borrowing limits and/or restrictions placed on them by lenders and investors could, once leases must be included on the aggregates operation’s balance sheet, be in violation of those agreements.

Analyze this

Every aggregates producer can analyze the costs of leasing versus purchasing with a discounted cash flow analysis, comparing the cost of each alternative by considering the timing of the payments, tax benefits, interest rates on a loan, the lease rate, and other financial arrangements. Unfortunately, while this sort of analysis is useful, the lease-or-buy decision can’t be made based solely on cost-analysis figures.

Generally, sand, gravel and crushed stone businesses with a strong cash position and good financing options can usually buy needed equipment outright, or they can borrow to acquire equipment with a long operating life. If obsolescence is a concern, a short-term operating lease often provides the biggest advantage and the most flexibility.

If cash flow is an issue and the equipment must remain operable for longer periods, a long-term capital lease, with a final residual payment will result in lower monthly payments plus a purchase option. However, short-term savings may result in higher costs over the entire leasing period. This is especially true with a finance lease where the user can purchase the equipment at the end of the lease. The aggregates operation may end up paying more over the long term. Obviously, it pays to determine any end-of-lease costs beforehand.

Although taxes play a role in whether to lease or to purchase, they should not be the deciding factor. Since a startling eight out of 10 businesses lease some equipment, would your sand, gravel or crushed stone business reap the long-term benefits of a lease?