Financing and Leasing
An Equipment Leasing Option that Works for You
With the many financing and leasing options available, it should be possible to find a structure that allows you to meet the unique tax, accounting and cash flow needs of your business.
The economic climate of the last several years has caused many business owners and municipalities to pay closer attention to how they fund needed equipment acquisitions. Matching payments to cash flows has become critical and the concept of using equipment financing or leasing to allow equipment to “pay for itself” has gained widespread acceptance. The tools available to a business owner for funding equipment acquisitions fall into two basic categories: financing (loans) and leasing.
Equipment financing, or loans, are relatively simple structures that allow you to spread the cost of a major capital equipment purchase over time. As the buyer of the equipment you will depreciate the equipment, expense the loan interest and benefit from any Section 179e deductions available to your company. Loan terms generally range from three to seven years but the length of term available may be dependent upon the age and type of equipment you are buying.
Most equipment financing and loans are done at fixed interest rates for the life of the agreement. Down payments may or may not be required based upon the credit strength of the borrower. For established companies with a good credit history, financing transactions typically provide 100 percent of the equipment cost, but may require that you make the first or first two payments at closing.
In a financing transaction, you are the owner of the equipment and the lender or finance company has a lien against it. Typically, you can pay off your loan early at any time during the term but most lenders will assess some type of pre-payment penalty based on the time remaining on the loan.
Loans or equipment financing are available from a variety of sources including banks, bank-owned equipment finance companies, independent finance companies and in some cases equipment manufacturers that have a captive organization to provide customer financing. Loans and equipment financing are generally available from most sources for vehicles and larger non-titled equipment such as grinders, large balers and other equipment used in MRFs, transfer stations, scrap yards and landfills. Equipment finance companies that specialize in financing waste handling equipment may also offer financing on containers, carts, compactors and portable restrooms.
There are a wide variety of leasing structures available to business owners. Each of them has different accounting and tax issues and it is highly recommended that any business considering equipment leasing consult its accounting and tax advisors to determine the leasing structure that best meets their needs.
The simplest form of equipment leasing is called a Capital Lease for accounting purposes. Most Capital Leases will provide 100 percent of the cost of the equipment and include a nominal amount (residual) due at the end of the lease, usually between $1 and 10 percent of the equipment cost. This residual amount may be structured as a Purchase Option but with solid or liquid waste equipment it is unlikely that it would ever make sense for a customer to return the equipment rather than keeping it, selling it or trading it in on new equipment.
For balance sheet accounting purposes, equipment on Capital Leases is usually either included with the other assets or may be listed separately as Capitalized Lease Equipment. On the liability side of the balance sheet, Capital Leases may be include with other debt or may be listed separately. For the income statement, equipment on Capital Leases will be typically depreciated in the same manner as the rest of the customer’s equipment and interest will be expensed. For tax purposes, Capital Leases will not typically qualify for the payments to be expensed, so much like a loan the customer will benefit from the depreciation and interest deductions.
Terminal Rental Adjustment Clause
One type of Capital Lease structure commonly used for truck purchases is called a TRAC (Terminal Rental Adjustment Clause) Lease. TRAC leases are available only on titled vehicles and typically have terms of three to five years. While a standard TRAC lease is a Capital Lease, the Internal Revenue Service has provisions that may allow you to expense the TRAC lease payments for tax purposes. In a TRAC lease, the vehicle is titled with the leasing provider as the owner and the customer has the option to purchase the vehicle at the end of the lease. The purchase amount is set up to approximate the anticipated future Fair Market Value, usually 20 to 35 percent of the original cost depending on the term. The customer may choose to return the vehicle in lieu of purchase, but if the equipment is returned the customer may be obligated to pay any shortfall between the amount the vehicle is sold for and the predetermined residual amount. Because the leasing provider in a TRAC lease owns the vehicle and benefits from the depreciation deductions, they can typically pass on a lower interest rate to you.
Many businesses use a TRAC lease structure with a term that matches the time that they expect to operate the vehicle. At the end of the lease they trade in the truck, payoff the residual amount and use any equity built up towards the purchase of the next vehicle.
Operating Leases are a more complex structure that may provide accounting and tax advantages to those businesses in a position to take advantage of their benefits. In a typical Operating Lease structure the equipment is owned by the leasing provide and the customer may have the option to purchase the equipment at the end of the lease term for its then Fair Market Value. There are accounting rules that dictate how much of the original equipment cost that the leasing provider may recover through the payments and also rules that govern the length of the lease term relative to the useful life of the equipment. If all of those rules are met, the customer may not have to report the equipment as an asset or the lease obligation as debt on the balance sheet. In an Operating Lease, the total amount of the payments paid each year would be an expense similar to amounts paid on rent equipment and the Operating Lease obligation that will be reported in a note to your financial statements similar to a lease for real estate. For tax purposes the customer typically can deduct the entire payment amount.
In lieu of purchasing the equipment for it’s then Fair Market Value, the customer may be able to walk away from the lease at the end of the term. This may appeal to businesses that have a contract and would not want the equipment after the contract expiration.
For those who believe that they will want to purchase the equipment at the end of the term, there are ways to structure an Operating Lease that can provide the tax and accounting benefits while giving the customer more control over the purchase amount. It is also possible to structure a vehicle TRAC lease with an anticipated residual in a manner that can quality as an off-balance sheet Operating Lease.
These options are more complex than can be addressed in this article, but an experienced leasing professional can work with you to identify and provide the structure that best meets your needs.
Many banks offer Capital Lease structures but fewer banks offer Operating Leases unless they have a separate leasing organization. Some independent finance or leasing companies and manufacturer’s captive financing organizations offer both Capital and Operating Leases for certain types of equipment.
Municipalities also have options available to fund capital equipment purchases. Municipal leases are available that allow a government unit to spend the cost of equipment over terms typically up to seven years. The leasing provider does not have to pay taxes on their income from municipal leases, so the rates are significantly lower than traditional business loan rates. These leases are available to cities, counties, towns, villages, boroughs, parishes and other governmental units such as solid waste districts and state universities. Municipal leases can be structured with monthly, quarterly, semi-annual or annual payments. Payments can be set up to match when tax revenues are expected or to meet cash flows based on user fees. Municipal leases require specialized documentation and will include language that allows the municipality to terminate the lease in the event that the fail to appropriate funds for payment. Because of the specialized knowledge and documentation required, there are fewer providers of municipal leasing.
The Best Solution
How do you determine the best financing or leasing structure for your company? First and foremost you should always gather information and advice from your tax and accounting advisors before choosing a financing structure. Your unique tax and accounting needs may dictate that one type of financing or leasing better meets your needs and it may change from year to year or even with the current year.
If you expect to keep the vehicles or equipment beyond the term of the lease or financing then a conventional loan or financing structure may meet your needs. If you are buying a titled vehicle and do not mind losing any Section 179e deduction, you may want to consider the lower interest rates and fixed purchase option of a TRAC lease.
Operating leases may make sense if you have a need to keep the asset and the obligation off of your balance sheet or if you need to be able to walk away from the equipment at the end of the lease term.
When considering loan or lease proposals from any source it is important that you look at all of the terms of the proposed financing. Too many businesses focus on the lowest interest rate without understanding all of the terms. This can be misleading as not all financing and leasing providers report their interest rate in the same manner. When gather financing and leasing information, you should ask for the following:
Amount of loan or lease
Length of term
What happens at the end of the term?
How much do I have to pay at the closing?
Consider all of this information for each proposal and you should be able to identify the best solution for your unique situation.
When you decide on a loan or leasing provider and are ready to execute documents, make sure that all of the terms shown on the documents match what was shown in your original proposal including any end of term options. With the many financing and leasing options available it should be possible to find a structure that allows you to meet the unique tax, accounting and tax flow needs of your business.
There are a number of financing and leasing providers that specialize in serving the needs of the solid and liquid waste industries. These companies come to the table with an understatnding of your industry and the equipment, and are best equipped to help you obtain the best financing solution for your business.
David Penoff is Vice President for the Environmental Service Division of TCF Equipment Finance, Inc. (Indianapolis, IN), providing financing and leasing for all types of solid and liquid waste equipment on a national basis. He has more than 30 years of experience financing solid and liquid waste equipment for contractors and municipalities. David has been a featured speaker for such groups as the Illinois CPA Society, national Association of Credit Managers and the Indiana State Bank Examiners. He has written extensively on Vendor Leasing Programs, Lease Marketing Ethics and Municipal Leasing. He can be reached at (877) 878-1161 or via e-mail at [email protected]