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What do "tax reasons" really mean?
The three tax-related issues most often cited are Payment Deductibility,
Mid-Quarter Convention, and the Alternative Minimum Tax. Here's a look
at each issue. Note: the three issues cited below assume that the type
of lease written is a tax lease, whereby the leasing company depreciates
the equipment and the customer deducts the payment as an expense.
Payment Deductibility:
Leases, if considered Tax Leases from a Federal Tax Perspective, are
fully deductible as a business expense. This is a particular advantage
if the lease payments are deducted over a shorter period than the depreciable
life of the asset. Note that the effective rate of a lease is sometimes
lower than that of a conventional loan because of the tax benefits that
the leasing company can use.
Mid-Quarter Convention:
The Mid-Quarter Convention is a concept referring to an income tax rule
triggered when 40% of all personal property acquired during a taxable
year is acquired in the last three (3) months of the taxpayer's taxable
year. If this rule is triggered, all personal property acquired during
the year is subject to the Mid-Quarter Convention. This means that instead
of the typical situation treating all equipment as depreciable for a
half year, the depreciation is recalculated for all equipment according
to the quarter of the year it was placed in service. This typically
leads to a significant reduction in depreciation allowed for the equipment
acquired during the first three quarters.
Alternative Minimum Tax:
The Alternative Minimum Tax (AMT) is a Federal Tax system for taxing
both individuals and corporations. It keeps a taxpayer from reducing
its tax below a certain level, almost like a speed limit for tax reduction.
If the tax liability calculated by the AMT rules exceeds the regular
tax, the taxpayer must pay the higher of the two calculations. This
is relevant from a leasing perspective because conventional equipment
ownership, with accelerated depreciation, increases the chances of the
AMT penalty. This is because accelerated depreciation is one of the
“tax preference items” noted in the AMT rules. In contrast,
tax lease payments are not tax preference items, and are not included
in the AMT calculation. This could result in substantial tax savings
to companies affected by the AMT.
Why is the fourth quarter of the
year so special in the leasing business?
The fourth quarter of a customer's tax year (and FNEF's tax year) is often
the best opportunity for leasing commercial equipment. Not only will this
help in avoiding the Mid-Quarter convention mentioned above, but FNEF's
tax benefits are at the highest during the fourth quarter for many transactions.
To the extent we can rely more on tax benefits for our return, we can
provide a more attractive rate and payment for the customer.
What is a Tax Lease?
A Tax Lease, sometimes known as a True Lease, is a Federal Income Tax
term. It means that the equipment lessor retains the tax benefits of equipment
ownership. In turn, the lessee will be able to deduct the entire payment
over the term of the lease, not an 'interest' portion, as with a loan
or conditional sale.
Tax leases are FNEF's most effective product for bank customers, partly
because such leases lead to lower payments than a typical loan. The reason
is simple: to the extent that FNEFs gets its return from the value of
tax benefits and lease-end residuals, it will rely less on payments for
the return.
What determines a tax lease payment
and yield?
Here are the primary factors that determine the payment and yield on a
tax lease:
- Month of Lease Commencement
- Equipment Type and Use (these affect the depreciable life)
- Term of Lease
- Frequency of Payments
- Timing of Payments (advance, arrears, etc.)
- Residual Value
- Other Structure Issues (examples: number of advance payments, use
of security deposits)
Why would a customer seek off-balance
sheet financing?
Some tax leases, if properly structured, may allow for off-balance sheet
accounting for financial reporting purposes, as defined by FASB rules.
This is referred to as an operating lease. Here are some possible reasons
a customer may have for an operating lease:
- Lender covenants
- Bonding requirements (ex. Contractors)
- Improved return on assets
- Improved debt ratios, both current and debt/equity ratios
What is a lease factor, and what
does it mean?
A lease factor is simply a multiplier, usually expressed in decimal form,
to determine the dollar amount of a lease payment using the equipment
cost. For example, a monthly factor of .0250000 for equipment costing
$100,000 would produce a monthly payment of $2,500. This is a commonly
used benchmark in the leasing industry, but the payment alone does not
tell the whole story. The customer's purchase option is an important consideration,
as is the customer's particular tax profile.
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