Equipment Lease Types

Equipment Lease Types

Each type of equipment lease is different. Knowing the basics is important if you’re thinking of leasing. Let’s review each type in more detail, starting with operating leases and finance leases, the two basic types of equipment leases, or, more specifically, the two basic types of lease classifications. From there, we’ll dive into lease classifications that fall within the two most basic types.

Operating Leases

An operating lease is a contract that permits one company to use another company’s equipment in exchange for fixed monthly payments over a specific period of time. To classify a lease as an operating lease, a number of criteria have to be met; one of the most distinct criterion includes the transfer of ownership, or, in the case of an operating lease, the lack thereof.

In other words, when the lessee and lessor enter into an operating lease agreement, the lessor retains ownership of the equipment during and after the duration of the lease, and the lessee accounts for the lease and its payments as tax-deductible operating expenses that can help reduce their taxable income. (Most operating leases have purchase options available, but you aren’t obligated to exercise them as the lessee.)

Because the payments and leased equipment are treated as operating expenses, this type of lease is often compared to a rental. Unlike a rental, however, operating leases are typically longer in length, ranging from 12 months to 5 years.

Operating leases can also be referred to as fair market value (FMV) leases when the option to purchase the equipment at the end of the lease for its fair market value is included. Under this type of contract, the lessee has the right, but not the obligation, to purchase the instrument at its fair market value.

This type of lease is highly useful when you don’t plan on keeping the instrument for a long time, due to risk of obsolescence or an upcoming shift in research, and while operating leases can last just a year, some leasing companies will lease equipment for longer lengths of time, ranging from two to five years. While the rates and terms of a lease agreement differ based on various factors, it is typical to see lower monthly payments the longer lease length you have.

You’ll have a number of options at the end of the lease term as well. These include:

  • Returning the equipment to the lessor free of charge,
  • Renewing the lease at a discounted rate,
  • Or purchasing the equipment at its fair market value.

As mentioned, the terms of the equipment lease agreement will differ depending on a number of factors: your company’s financial health, credit rating, industry, the equipment you want to lease, and for how long you want to lease.

You may also see operating leases referred to as true leases. This is because a true lease shares the same characteristics as an operating lease. Specifically, it does not include the transfer of ownership of the equipment from the lessor to the lessee.

Finance Leases (or Capital Leases)

A finance lease, or capital lease, also grants a lessee the rights to use a lessor’s equipment. However, unlike an operating lease, a finance lease is treated like a loan, and involves the “transfer of ownership” from the lessor to the lessee.

What transfer of ownership means here is that certain rights and risk of loss of the equipment are transferred to the lessee in exchange for scheduled payments. The lessee treats the lease as a purchase and it is treated as both an asset and a liability on the balance sheet. Ownership of the equipment is typically retained by the lessor, however, the lessee is guaranteed the option to purchase the equipment at the end of the lease at a price far below its fair market value, transferring ownership from the lessor to the lessee.

Historically, finance leases were quite different from operating leases under previous accounting standards. However, with the implementation of ASC 842, these differences have been reduced, as operating leases are now also typically accounted for on the balance sheet. The only exception is when a lease is less than 12 months in length. Then it is treated simply as a rental and is accounted for as such.

Despite the recent updates, some minor differences remain. Since a finance lease is treated like a purchased asset, the lessee can depreciate the equipment and the interest payments, allowing for tax deductions that lower the company’s taxable income.

Generally speaking, the IRS will treat your finance lease as if you are taking out a loan for your lab equipment. Instead of recording rental expenses on your income statement, you will record a debt on your balance sheet along with the corresponding principal payments. Finance leases can also come with burdensome terms typical of a bank loan, since they are identical debt instruments.

Finance leases, like debt, accrue interest. When tax season comes around, under current IRS rules, you can deduct the interest expense, but these deductions can be lower than an operating lease.

The differences between finance leases and operating leases are nuanced.

$1 Buyout Lease

A $1 buyout lease is another type of finance lease companies can opt for. It works in the same way as a capital lease in that a lessee makes monthly payments for a piece of equipment until, at the end of the lease period, they can buy the equipment for a lower price than its fair market value. In this case, the company is guaranteed the option to buy the instrument for $1, thus the name, “$1 buyout lease.”

This type of lease makes the most sense when the company is positive that they want to use the equipment long-term and eventually own it. A $1 buyout lease is structured so that the bulk of the equipment’s cost is paid during the lease term, with the final $1 purchase solidifying actual ownership.

Additionally, $1 buyout leases, like finance leases, offer a number of tax benefits that might be worth considering, such as depreciation and interest.

Purchase Option Lease

Another equipment leasing option includes leases with a 10% purchase option, often referred to as a $10 purchase option lease or 10% option lease. Under a lease agreement with a 10% purchase option clause included, the lessee is given the option to buy the equipment at the end of the lease for 10% of the original purchase price—90% of the lease is paid for upfront through the monthly lease payments.

What this accomplishes is that it lowers the monthly payment amount by deferring 10% of the equipment’s price to the end of the term. In addition to the ability to purchase the item for 10% of its original value at the end of the lease, the lessee is afforded the chance to opt out if they feel that the equipment isn’t useful or worth buying outright—this might be due to obsolescence or something else. Saving 10% doesn’t sound like much, but it can really add up when the equipment is extremely expensive, like in the case of most biotech and life sciences equipment.

In addition to the 10% option lease, a 10% PUT lease option is available. Standing for “purchase upon termination,” the PUT lease is similar to a lease with a 10% purchase option, however, under the 10% PUT contract, the lessee cannot opt out of the purchase at the end of the lease.

The lessee agrees to the lease contract and pays monthly payments for the term of the lease equal to 90% of the equipment’s value. Like the 10% option lease, 10% of the equipment’s value is deferred to the end of the term. This can lower the payments compared to a traditional $1 buyout lease, but it also locks in a full sale. This type of lease really makes the most sense when a lessee is positive they want the item, and is sure that the remaining value of the equipment will be worth more than that final 10%.

Sale-Leaseback (or Leaseback)

A sale-leaseback (SLB) has a number of different names: sale-leaseback transaction, sale-and-leaseback, or, simply, a leaseback. No matter what the name is, they all refer to the same thing: the sale of a piece of equipment, and then the subsequent leasing back of it to another party. It is known for being an effective tool in equipment financing that can positively impact your cash flows and runway, serving many companies in capital-intensive industries well due to the high costs of analytical lab equipment.

When you conduct a sale-leaseback transaction or arrangement, you sell the equipment you recently purchased to another company in order to recoup what you paid for the instrument. In most cases, the company you’re selling to is a leasing company or lender, who then leases that equipment back to you, allowing you to pay for the instrument over multiple years through flexible lease payments rather than paying for it all up front.

In other words, you can use an SLB to raise capital and continue using the equipment you need. This is often an ideal option for companies that rely on expensive equipment but need to allocate CapEX or OpEx to other areas.

TRAC Lease

A TRAC lease, short for terminal rent adjustment clause lease, isn’t really applicable to equipment leasing, since it’s mostly used to lease vehicles. However, some vehicles can be considered heavy equipment, so we’ll quickly review TRAC leases here.

Under this type of agreement, the lessor and lessee enter into a credit agreement. After, the lessor purchases the equipment from a vendor of the lessee’s choice. The lessee then agrees to pay fixed monthly payments for a specific period, similar to any lease agreement. However, the payments of a TRAC lease are based on the equipment’s future price, and the formula that leases usually adhere to—leases for renting have a large residual and leases for buying have a small residual—is played with a bit, adding some flexibility to the lease agreement. Essentially, the lessee can negotiate the residual and monthly payments, opting to make a large residual payment in order to lower monthly payment obligations.

TRAC leases can be either a finance lease or an operating lease, depending on how the agreement is written.

When Does Equipment Leasing Make Sense for Your Business?

Now that you know more about different types of equipment leases, you should consider whether or not it makes sense to actually lease right now. Before you start any planning, ask yourself some simple questions:

  • Will the equipment meet an important operational need that’s currently unmet?
  • Does the cost of continuing to use the equipment I already have, with repairs or inefficiencies taken into consideration, justify the price of acquiring new equipment?
  • Does the new equipment fit into my overall business plan? If so, how?
  • What is my expected return on investment? Will the equipment lead to a discovery or product that can turn into a profitable revenue stream for me?
  • If I wait a little longer before bringing in new equipment, will new models become available that include features I can rely on to improve my operations?
  • Do I have enough free cash flow to enter a lease agreement without needing to sacrifice more urgent spending priorities today or down the road? Or, will the lease agreement help me with cash flow so that I can invest in other areas of business?

After asking yourself these questions, consider your company’s taxes and accounting situation: does a certain type of equipment lease offer more advantageous tax benefits than another? Speak with an accountant to determine this. Depending on your situation, an operating lease might make more sense than a finance lease, or vice versa.

Leasing Doesn’t Limit Your Capital

Many types of equipment can be exorbitantly expensive. The high costs of specialized industrialization might make buying outright a bad option for many developing companies.

Equipment leasing can help your business grow more quickly. No down payments, fixed monthly lease payments, and tax-deductible operating expenses help you preserve cash, extend runway, and reinvest in core areas of business, all while potentially reducing your taxable income.