The tax implications of leasing business equipment are different from that of purchasing it.
In order for you to get the benefits of tax implications, you have to first of all understand that there is a difference between buying and leasing. Under a typical lease agreement, you are entitled to deduct lease payments if you lease property for your business. You have to remember that there are certain conditions under which the IRS may refuse to give you deductions such as if they find out that what you are trying to portray as leasing equipment is actually repayment of an installment or a conditional sale.
What’s The Difference In Tax Benefits For Leasing Business Equipment And Purchasing It?
Why does the IRS concern itself so much about whether you have leased business equipment or purchased it? This is because when you purchase business equipment, you will deduct depreciation for the purpose of taxation. When you lease your equipment, you will be allowed to deduct rental payments. In order to understand why the IRS cares whether you purchase or lease your equipment, picture this.
Mr. Smith’s restaurant is interested in a piece of kitchen equipment that costs approximately $35, 000. However, since this is way out of his budget, he decides to lease the equipment at $12, 000 per annum for three years. In the lease agreement, Mr. Smith has the option of purchasing the equipment at the end of the lease period for $2, 000. Rental value for Mr. Smith’s equipment is $5, 000. What reason would explain why Mr. Smith and his lessor would choose this route?
According to Mr. Smith, leasing is the only way that the equipment would effectively recover its cost over three years through deduction of lease payments. If he had purchased the equipment, he would have recovered the expenses over five years through depreciation deductions. The IRS does not like inappropriate increase in the rate of deductions.
From the equipment leasing company’s perspective, leasing the restaurant equipment allows it to evenly spread its income over a three year period. The IRS dislikes improper deferment of income.
Your lease payments will not be deductible if the IRS recharacterizes your lease as a sale. You will only be eligible for depreciation deductions for tax purposes because you are the owner of the property. A part of your lease payments, which the IRS considers as down payments for purchasing the equipment, can be deducted because they consider those payments to be interest.
Why The IRS Would Recharacterize Your Lease
In the example of Mr. Smith’s restaurant, the IRS would most likely recharacterize his lease. The following are some other reasons why the IRS recharacterizes leases.
- A part of your lease payments are considered as interest.
- A part of your lease payments establishes equity in the leased equipment.
- Ownership of the equipment is transferred to you after paying a certain amount of lease payments.
- Your lease payments are made in a very short period of time and are much more than the amount you would normally pay to purchase the equipment.
- The fair rental value of the equipment is far less than the lease payments you make.
- When your total lease payments would be more than the nominal value of the property when purchased.
If any of the above elements describe the type of lease agreement you are about to sign, then you should proceed with caution to avoid penalties and interest payments from the IRS if they recharacterize your lease. If you do not know how the IRS may view your lease, you should consult a trusted financial advisor and they will advice you on how to proceed.
Summary
Leasing business equipment can save your business if:
- You are a start-up and you don’t have the money to purchase the equipment outright
- Your business isn’t at its peak and you don’t have enough cash flow to purchase equipment you need.
- You only need the equipment for a short period of time.
Leasing business equipment has plenty of tax benefits but you must take necessary precautions to ensure you maximize the benefits. If you are not sure your lease agreement is suitable for your business, you should have an expert review it first.
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