All You Ever Wanted To Know About Leasing (But were afraid to ask)

by Thomas Terry

Conceptually, an operating lease is a method of acquiring the use of equipment rather than the ownership of an asset. Thus, since the lessee does not own the equipment but rather is leasing the equipment over a period of time, the full lease payment is treated as a deduction and there is no depreciation or interest expense.

Leasing is one of the most common methods of acquiring equipment, and can also be one of the most misunderstood methods. What makes leasing seem confusing is all of the different terms and phrases used in the industry such as: true lease, operating lease, capital lease, finance lease, sale-leaseback, master lease, full-payout lease, $1 buyout purchase option, fair market value purchase option and on and on and on…..

For purposes of acquiring equipment, a company will either use (1) an operating lease, which has both tax and GAAP advantages, or (2) a finance lease, which for tax and GAAP purposes is treated identically as an installment loan. Conseq-uently, the asset is shown on the balance sheet and the interest and depreciation expenses are on the income statement. There is no tax ramification with a finance lease.

The general characteristic of an operating lease is that the ownership of the equipment resides with the lessor (owner). For this reason the equipment is not shown as an asset nor is the lease shown as a liability on the balance sheet of the lessee (user). This is referred to as an "off-balance sheet" transaction. Conceptually, an operating lease is a method of acquiring the use of equipment rather than the ownership of an asset. Thus, since the lessee does not own the equipment but rather is leasing the equipment over a period of time, the full lease payment is treated as a deduction and there is no depreciation or interest expense.

There are several requirements which must be met under FASB 13 for GAAP as well as IRS requirements for a transaction to be considered an operating lease. A few of the significant ones are as follows:

• The purchase option at the end of the lease term must be at the fair market value. If it is less than fair market value (i.e. $1 buyout), the transaction is construed to be an installment sale and assumed ownership is with the lessee.
• At the end of the lease term, the asset must have at least a 25% useful life remaining. Under the same reasoning as above, if there is less than 25% useful life remaining it is construed that the lessee used the asset until there was no va|lue remaining and thus "owned" the asset.
• The present value of the minimum lease payments cannot exceed 90% of the purchase price of the asset. This means that the lessor has an equity position in the asset and thus is owner of that asset.

There are several other "tests" which the IRS and GAAP can use to determine if the transaction is an operating lease. The key variable in the thinking behind operating leases has to do with ownership. All of the requirements deal with the question of whether ownership ever passes from the lessor to the lessee during the lease term.

Advantages Associated with an Operating Lease Include:

• Off-balance sheet financing;
• Deduction of the full lease payment rather than just the interest and depreciation expense;
• The asset can be turned back to the lessor at the end of the lease term.

When making a "lease versus buy" decision there are several factors which should be considered. For instance, does the asset being acquired have a long useful life? If so, there may be a large purchase option at the end of the lease term if the fair market value stays high. Is it important for the transaction to be "off-balance sheet" due to debt covenants or high leverage? If so, an operating lease may fill the bill.

As with all major transactions it is important to seek counsel from your financial advisors as to your particular tax situation and whether a particular lease will be treated as an operating lease for tax and GAAP purposes.

Thomas S. Terry is the Senior Vice President of UMB Bank, n.a. He can be reached by phone at 816.860.7932 or by e-mail at thomas.terry@umb.com.