If your business needs to acquire equipment or machinery, management faces a tough decision: whether to lease or buy. No universal right answer exists, but the following considerations can help you make the best choice for your business.
Take Advantages of Purchases
Purchasing equipment comes with major federal income tax incentives, including the following first-year depreciation tax breaks.
100% first-year bonus depreciation deductions. New and used qualifying business assets placed in service between September 28, 2017, and December 31, 2022, qualify for 100% first-year bonus depreciation. For certain assets with longer production periods and aircraft, the placed-in-service deadline extends to December 31, 2023. This tax break will gradually phase out from 2023 through 2026.
Section 179 deductions. For tax years beginning in 2020, a business taxpayer can potentially write off up to $1.04 million of the cost of qualifying new and used assets with the Sec. 179 deduction. Under a phaseout rule, the maximum $1.04 million Sec. 179 deduction for tax years beginning in 2020 reduces dollar-for-dollar by the excess of Sec. 179 deduction-eligible asset additions over $2.59 million.
The allowable deduction for a tax year can’t exceed the taxpayer’s aggregate net business taxable income from all sources calculated before any Sec. 179 deductions. That means Sec. 179 deductions can’t create or increase a federal income tax net operating loss (NOL). Deductions that would create or increase an NOL are disallowed and carried forward to the following tax year.
Finally, if your business operates as a pass-through entity — such as a limited liability company (LLC), partnership, or S corporation — the $1.04 million Sec. 179 deduction maximum, the $2.59 million deduction phaseout threshold, and the business taxable income limitation apply at both the entity level and your personal level. The interactions of these limitations can cause allowable Sec. 179 deductions for a year to be less than expected.
It does not always make sense to claim 100% bonus depreciation and/or Sec. 179 deductions in the year the business places qualifying property in service. Instead, one may choose to depreciate those assets over several years under the Modified Accelerated Cost Recovery System (MACRS). (See “Now or Later?” below.)
Under MACRS, the cost of qualified property placed in service is recovered over its useful life, with larger write-offs available in the early years of ownership. For manufacturers, most equipment or machinery will have a useful life of seven or 15 years.
Important: Accelerated depreciation methods — including 100% first-year bonus depreciation, Sec. 179 and depreciation over the asset’s useful life under MACRS — are available even if you finance a machine or equipment purchase, rather than buy it outright.
Other Considerations When Buying Equipment
Besides the tax benefits, when your business buys equipment, you don’t have to worry about a lease term expiring — the asset remains yours to keep for as long as you want. But two organizations should consider two major downsides.
1. Significant upfront costs. Purchasers must pay the full cost of property upfront or finance the purchase and then make monthly payments, which include interest charges. If you finance a purchase, you’ll also have to provide a down payment. Plus, the business must record the equipment loan on its balance sheet, which could affect your credit rating and possibly trigger loan covenants.
2. Risk of obsolescence. There’s a risk that purchased equipment, especially high-tech items, could become outdated. Machines considered obsolete do not sell easily.
Pros and Cons of Leasing
Over the short run, leasing may appear more cost-effective than buying. For starters, leases typically don’t require a large down payment — and, for companies with credit issues, leases may be easier to obtain than equipment loans. Lease payments usually run lower than loan payments because you pay only to use the asset for the term of the lease. Once the lease expires, you generally return the asset to the leasing company, unless you exercise a right to buy the asset at the end of the lease term.
A leased asset will not likely become outdated before the end of the lease term and upgrading a lease can be done with greater ease if it does become outdated. But the downside remains that your company doesn’t own the machine after the lease term.
Over the long haul, leasing may cost more than buying because you must continuously renew the lease or acquire a new one. Additionally, when you lease equipment, you commit to a specified term, so you must keep making lease payments, even if you stop using the property.
From a federal income tax perspective, you can generally deduct lease payments as “ordinary and necessary” business expenses, but leased assets don’t qualify for 100% first-year bonus depreciation, Sec. 179, or depreciation over the asset’s useful life under MACRS. These accelerated depreciation methods only apply to asset purchases, not leases.
Changes to Lease Accounting Rules
Updated accounting rules issued by the Financial Accounting Standards Board (FASB) require companies that follow U.S. Generally Accepted Accounting Principles (GAAP) to report lease obligations on their balance sheets. This change improves transparency about current off-balance-sheet leasing activities.
Specifically, Accounting Standards Update (ASU) No. 2016-02, Leases (Topic 842), requires companies that lease fixed assets (lessees) to recognize all leases with terms of more than 12 months on their balance sheets, regardless of their classification as capital or operating leases. The change requires lessees to report a right-to-use asset and a corresponding liability for the obligation to pay rent, discounted to its present value by the rate implicit in the lease or the lessee’s incremental borrowing rate.
For public companies, the updated lease standard took effect in 2019, but private companies received a reprieve during the COVID-19 pandemic. The FASB has decided to amend the effective date for private companies to annual reporting periods beginning after December 15, 2021. This postponement eases the pressure in the current uncertain economic environment. However, private lessors will eventually have to transition to the new rules.
The change to the accounting rules effectively makes leasing less attractive because affected companies can no longer bury operating lease obligations in their footnotes. They must be reported, along with other liabilities, on the face of the company’s balance sheet under GAAP.
Practical Advice
If your business intends to acquire additional equipment or machinery, contact your tax and accounting advisors to review the situation carefully. They can evaluate the pros and cons to help you make an informed decision.
Deduct Now or Later?
Many manufacturers expect to report lackluster financial results in 2020 due to the COVID-19 crisis. Sec. 179 deductions can’t create or increase a federal income tax net operating loss (NOL). Deductions that would create or increase a net operating loss (NOL) are disallowed and carried forward to the following tax year.
However, 100% first-year bonus depreciation write-offs can create or increase an NOL that, under the CARES Act, you can potentially carry back for up to five tax years to recover federal income taxes paid for those earlier years. That can be a big help for a cash-starved manufacturer.
Beware: It’s not always prudent to immediately deduct the cost of purchased equipment and machinery. Reasons to depreciate assets placed in service in 2020 over time, rather than claim first-year 100% bonus depreciation and/or Sec. 179 write-offs, include:
1. To shift depreciation write-offs to future years, when tax rates may be higher than today. When you claim 100% bonus depreciation or Sec. 179 deductions, you effectively front-load your deductions. That is, your federal income tax depreciation deductions for future years are reduced by your first-year deductions. If federal income tax rates go up in future years, you’ve effectively traded more valuable future year depreciation write-offs for less valuable first-year write-offs.
2. To maximize the QBI deduction for owners of pass-through entities. An individual taxpayer can claim a federal income tax deduction for up to 20% of qualified business income (QBI) from an unincorporated business activity. However, the QBI deduction from an activity can’t exceed 20% of net income from that activity, calculated before the QBI deduction. Claiming first-year depreciation deductions will reduce net income and potentially result in a lower QBI deduction.
Important: The QBI deduction is scheduled to expire after 2025 — and it could disappear sooner, depending on tax law changes. So, it may be a use-it-or-lose-it proposition. If you forgo big first-year depreciation deductions, your allowable QBI deduction may be higher. However, foregone first-year depreciation isn’t lost. It’s just deducted in later years when depreciation write-offs might be more valuable because tax rates are higher.
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Our firm provides the information in this e-newsletter for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles in this e-newsletter are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.
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