Depending on the small business you own, some form of equipment might be essential in order for your company to operate. Since equipment is costly, many small firms might not be able to purchase everything they require upfront. Leasing equipment is a means to stretch out the expense over a predetermined period. Leasing can be considered as an alternative small business financing option.
Equipment for a small business could take the form of machinery for manufacturing, computers, printers, cameras, grills, furniture, kiosks or an almost infinite range of other items depending on what your company sells. But, in many cases, the cost of outright ownership of equipment needed for a small business could be prohibitive.
Buying the equipment needed to operate a company could end up being the financial backbreaker that sinks that company. Small business owners usually do not have unlimited funds at their fingertips, and another solution could be needed to secure the equipment needed for the business to operate.
Leasing equipment for a small business could be the answer. By leasing the equipment necessary to operate a company, you might be able to disperse the cost of paying for that equipment over a set amount of time, a key consideration when you’re concerned about maintaining cash flow in your business.
With equipment leasing, a small business owner pays a fixed rate over a specific period. The interest and fees are built into the payment. Contracts to lease equipment could cover anywhere from three to 10 years, depending on the nature of the equipment you will be borrowing.
Purchasing and maintaining equipment can strain the expenses of many entrepreneurs. Some equipment might be on the cutting edge today but could then become quickly outdated within a couple of years. If you buy expensive equipment, you’d better make sure it’s going to last, and if what you have is destined for obsolescence, that becomes a sunk cost that could sink you and your business altogether. You also have to be concerned about depreciation of the value of such equipment if you bought it.
Owning and operating your own equipment is both expensive and risky. Leasing the same equipment might save you money and also minimize the risk of being stuck with outdated equipment that could affect the level of quality control your company is able to have.
If you lease equipment instead of purchasing it, you’ll usually have months or even years in which to pay for it, instead of being forced to ante up a massive up-front payment that could put you deep in the red right out of the gate. Sometimes, commercial equipment leases will come with service agreements or service add-ons.
If you lease equipment for your small business, when the lease term is up, you can give the equipment back to the owner from whom you leased it, or you might also be able to buy the equipment for a depreciated price — if, of course, we are talking about equipment that is not obsolete. In that case, you would be leasing to own, eventually.
In an equipment leasing arrangement, the lessor–the company from which you are leasing–purchases equipment or other fixed assets. You, the business owner, then enter into a contract with the lender to use the equipment, or asset. In return for the use of the equipment, you make fixed monthly payments to the leasing company for a specified period.
What are the two types of equipment leases?
There are two types of leases: An operating lease and a finance lease.
1) Operating lease:
If the type of equipment you are leasing is small and not of exorbitant value, you’re more likely to enter into an operating lease agreement. In an operating lease, a business owner rents an asset from a lessor, but not under terms that transfer ownership of the asset to the lessee. During the rental period, you would have unrestricted use of the equipment, but you are responsible for the condition of the equipment when the lease is up and you have to return the equipment to the entity from which you leased the equipment. Your lease payments are considered to be operating expenses, and they are deducted right away from operating revenues for accounting and tax purposes.
2) Finance lease:
With a finance lease, the small business owner identifies the equipment he or she needs for the business. Then, the finance company from which you would be leasing the business equipment, buys the asset (i.e., the equipment). After that, you enter into a contract with the lessor that grants you access to the equipment during the life of the lease. While you, the small business owner, are using the equipment for your company, you are making regular payments to the lessor for the right to use the equipment. The lessor recovers the cost of the asset plus interest. When the equipment financing lease agreement is up, you have the option to purchase equipment outright that you’ve been leasing.
Once you enter into a contract for a finance lease, you cannot cancel the lease–which is frequently referred to as a full-payout lease or a closed-end lease. The lease payments recover most of the equipment cost for the lessor together with interest on the investment. Financial leases must be capitalized as a liability on the lessee’s balance sheet.
Before you enter into a finance lease, it’s a good idea to consult with a qualified certified public accountant (CPA) who knows about accounting for leases, because their terms are complicated and even savvy businesspeople can get tripped up by their intricacies.
Is Equipment Leasing Tax Deductible?
Payments that a small business owner makes on an agreement to lease equipment can be deducted as rent, provided that it doesn’t qualify as a conditional sales contract, according to the Internal Revenue Service (IRS). These conditions include whether you receive ownership of the property upon completion of the payment period and whether parts of the payment are clearly designated or recognizable as interest, among other factors.
The IRS states that the agreement is a conditional sales contract, and not a lease, if one or more of the following conditions apply:
- The agreement designates part of each payment towards an equity interest that you’ll receive in the property.
- You get title to the property upon the payment of a stated amount of “rental” payments required under the agreement.
- The amount you must pay to use the property for a short time is an inordinately large part of the amount you would pay to get title to the property.
- You pay much more than the current fair rental value for the property.
- You have an option to buy the property at a nominal price compared to the value of the property when you may exercise the option. Determine this value when you enter into the agreement.
- You have an option to buy the property for a small amount compared to the total amount you have to pay under the agreement.
- The agreement designates some part of the payments as interest, or parts of the payments are easy to recognize as interest.
Renting Equipment vs. Leasing Equipment
Although people frequently use the terms “rent” and “lease” as if they are the same thing, there are significant differences between the two when it comes to equipment leasing for startups as opposed to the rental of equipment needs for your business.
The time frame of a rental is much shorter than that of a lease and is usually on a month-by-month basis for short-term period. That makes renting equipment for your business easier to get out of if something’s not working out properly, but, while that might seem less daunting on the surface than leasing equipment would be, there are some clear-cut advantages to leasing instead of renting, as well.
While the terms of a month-to-month rental might seem more flexible, monthly repayments are often higher for a rental than they would be with an equipment lease. And, at the end of a rental period, you don’t have any option to purchase the equipment the way you would with a lease. You either have to give the equipment back or renew the agreement for as long as you continue to want or need to use the equipment. On the other hand, when you agree to equipment leasing, you generally have the option to purchase the equipment at the end of the lease term.
Thus, renting equipment for a small business could, in the long run, cost your company more than it would to lease the same equipment.
Another Option to Consider: An Equipment Loan
In addition to considering leasing equipment for their small business, entrepreneurs may also be mulling the possibility of applying for a loan to finance the purchase of equipment.
A loan that is secured for the purpose of buying equipment, an equipment financing loan is secured by the equipment itself. A business that can’t afford to pay off the loan would end up surrendering the equipment as collateral.
If cash flow impedes the purchase of vehicles or machinery, small businesses can turn to small equipment loans in order to finance the heavy-duty parts they need to make a go of things. A number of providers ranging from traditional banks to alternative lenders are available to lend money for equipment. The interest rates for an equipment loan could be anywhere from 6 percent to 9 percent.
Businesses must come up with a down payment of between 10 and 30 percent in an equipment loan agreement. The lender will finance the rest.
When a business’ equipment starts to wear out or become outmoded, and the company still needs that type of equipment to operate at maximum efficiency and productivity, then the business needs new equipment and a way to pay for it.
A small business operating on a limited budget may see financing equipment as an attractive option to preserve its cash on hand by dispersing the funding of needed equipment over several months or years in predictable, equal payments.
Assets whose value is unlikely to depreciate much are suitable subjects for equipment financing.
For many small businesses, equipment can be financed up to 100 percent of its value. Most lenders will set the term of the loan equal to the equipment’s expected useful life. Most computers and software have an expected useful life of between three and five years, according to actuarial website AssetWorks.
Why should you apply for an equipment loan?
There are three reasons business owners would apply for an equipment loan:
1) As a replacement for aging equipment
2) In order to upgrade existing equipment that, while still functioning properly, may be becoming outmoded.
3) As an addition to a company’s present inventory of equipment
Some of the businesses that would most likely be in the market for an equipment loan include auto body shops, farming businesses, construction companies, healthcare providers, restaurants, shipping companies, manufacturers, creative agencies and IT firms, among others.
To qualify for an equipment loan, you must satisfy lender requirements in several areas including your credit history, business and personal credit scores, time in business, annual revenue, a financial statement, and the sort of equipment you are buying.
Benefits of equipment loans
Turnaround time for approval, tax deductibility and the ability to retain more working capital are just some of the things that make equipment loans an attractive option for small business owners mulling financing options.
1) An application for an equipment loan is likely to meet with fairly prompt approval. Applying through an online lender may also facilitate the application process. Quicker funding can mean a faster path to upgraded inventory and better equipment or machinery to make one’s business run smoothly.
2) The monthly payments on an equipment loan may be deductible as an operating expense. To know for certain, small business loan applicants are best advised to check with not only the lender, but with a tax attorney.
3) A small business obviously needs liquid funds for plenty of other purposes besides buying new equipment, and an equipment loan can benefit them by enabling them to have more cash on hand. Not all expenses are planned for and having extra cash on hand could be vital if an unforeseen expense such as a repair comes up. Equipment loans can be used to replace or repair items the company needs to keep operating.
4) Payment schedules may be more flexible with equipment loans. Depending on the lender, there may be an option to select from paying monthly, quarterly, biannually or annually. Such flexibility could be a godsend for a business needing to function normally while still paying off its loan on business equipment.
Whether a company’s equipment is malfunctioning and the need to replace it is imperative, or current equipment is still functioning properly but is beginning to become outdated, an equipment loan can help keep a business competitive by having equipment that is closer to state of the art level.
If equipment is beginning to malfunction, a business owner may be weighing the cost of simply getting the present equipment repaired against the prospect of purchasing a replacement. A loan for new piece of equipment may figure to be more sustainable than a steady stream of repair work to the same old equipment.
Deciding How to Finance Your Equipment
No matter how you decide to finance your equipment, make sure the conditions fit your company’s needs by doing the calculations and carefully reading the contract. You may want to look into alternative types of funding that Biz2credit provides to get the money your company needs to grow and succeed.