Jack has decided to take a leap and start his own business. He has put together a marketing plan, gathered a team of great advisers and arranged for financing. He has a few pieces of equipment, but also has a long list of additional equipment needed so that he can offer his customers high-quality products and services. Jack must now determine whether to purchase or lease the additional equipment.
There are substantial benefits to leasing the equipment rather than purchasing. The obvious benefit for a new company is that there is little to no capital expense to obtain the equipment. Additionally, Jack’s equipment lease payments are a tax deductible business expense.
However, Jack must consider the downside of leasing. He and his accountant determined that it would cost more over the life of the equipment to lease rather than purchase. Jack decides he can manage these increased long-term costs and elects to minimize his current capital contributions. He will lease.
After carefully considering his options, Jack decided to lease his new equipment from Smith Leasing Company. He and his accountant are comfortable with the monthly payments and are ready for the next step – signing the Equipment Lease. When Jack reads the lease, there are a few provisions he (and his lawyer) should look at carefully:
• Termination: Equipment leases will generally provide that the lessor (Smith Leasing) can terminate the lease if the lessee (Jack) fails to make the lease payments. The lease should also state that his company can terminate if Smith Leasing breaches the lease, including any failure to maintain the equipment or repair it in a timely manner.
• Insurance: The lease will may require Jack’s business to maintain insurance on the equipment during the term of the lease. Jack should work closely with his insurance broker to ensure that the amount of coverage and the deductibles comply with the lease. The policy may also need to name Smith Leasing as an additional insured.
• Maintenance: In many cases, the leasing company will maintain and repair the equipment during the term of the lease. If the lease provides otherwise, Jack should factor in the costs of the maintenance and repair into the business budget and evaluate whether the requirements are too cumbersome.
• Personal Guaranty: The lease should be between Smith Leasing and Jack’s business, not Jack personally. Jack’s business is new (and has little to no financial history), so Smith Leasing may request that Jack and any other owners of the business personally guaranty performance of the lease. Jack should consider this carefully – and avoid it if at all possible – because he will personally be on the hook for the lease payments regardless if his business survives the lease term.
Five years pass and Jack’s business is doing remarkably well. The term of the equipment lease will expire shortly and Jack is evaluating whether he should purchase equipment rather than renew and renegotiate the lease. Capital outlays are now less of a concern and the longer-term tax benefits of equipment depreciation are more appealing. Now, the most significant drawback is potentially maintaining possession of outdated equipment. After crunching the numbers, Jack decides to purchase the equipment, and evaluates acquisition options.
Jack could purchase the equipment in the name of his business. The business would then get the tax benefits of depreciation of the company-owned equipment, and would be in control of the maintenance schedule and standards of repair.
Alternatively, Jack could form a separate company to own and lease the equipment to his current business. Jack would form a new company, personally contribute the funds to purchase the equipment and operate the equipment company separate and distinct from Jack personally and Jack’s continuing operating business. The equipment company could then enter into an equipment lease with the operating business, which lease would contain provisions similar to those discussed above. The equipment company would take advantage of the depreciation benefits, while the operating business would deduct the lease payments.
This strategy seeks to optimize the overall tax benefits to Jack, as a common owner of both the equipment company and the operating business. However, this strategy may not work for everyone. In some highly regulated industries, there are severe limitations on these types of equipment leasing arrangements. If you think that this strategy may work for your business, it is best to work closely with your accountant and attorney to evaluate the leasing relationship and to thoroughly and accurately document the relationship.
Amy E. Geerhart is an attorney in Sussman Shank’s Business Group with experience in contract review and negotiation, sales and acquisitions and general corporate matters. Contact her at 503.227.1111 or email@example.com.