Capital Leases versus Operating Leases

By Jason Watson, CPA
Posted Saturday, November 4, 2023

One of the problems facing small business owners is disguised purchase payments. This happens often when a business leases a copier (for example) for 60 months and then has an option to own the equipment after the lease term expires. We’ll talk about that in a second.

The other issue with operating leases is that you cannot depreciate the asset. The most common situation is a leased automobile for the business. Since your automobile lease does not typically qualify as a capital lease, then it is considered an operating lease. The good news is that your lease payment contains the reduction in value (the difference between sales price and residual value), and as such you are receiving some “depreciation” in heavy air quotes with your tax deducted lease payments. The downsides are- a) they are limited to the degradation in value only and b) they are not accelerated.

Back to the capital lease situation. A true lease payment is deductible in full each month, but an installment purchase payment is only deducted to the amount of finance or interest charges.

Here is the blurb from IRS Publication 535–

Lease or purchase. There may be instances in which you must determine whether your payments are for rent or for the purchase of the property. You must first determine whether your agreement is a lease or a conditional sales contract. Payments made under a conditional sales contract are not deductible as rent expense.

Conditional sales contract. Whether an agreement is a conditional sales contract depends on the intent of the parties. Determine intent based on the provisions of the agreement and the facts and circumstances that exist when you make the agreement. No single test, or special combination of tests, always applies.

However, in general, an agreement may be considered a conditional sales contract rather than a lease if any of the following is true.

• The agreement applies part of each payment toward an equity interest you will receive.

• You get title to the property after you make a stated amount of required payments.

• The amount you must pay to use the property for a short time is a large part of the amount you would pay to get title to the property.

• You pay much more than the current fair rental value of 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 make the agreement.

• You have an option to buy the property at a nominal price compared to the total amount you have to pay under the agreement.

• The agreement designates part of the payments as interest, or that part is easy to recognize as interest.

There’s no real value added by exploding all these factors into drawn out explanations. The most common lease problem is the $1 buyout or something similar- be careful what you are getting into with leases that might be disguised as purchases. Not a huge deal, but the accounting and subsequent business deduction will be different.

In the accounting world we call this example a capital lease (as opposed to an operating lease). Here are some more signs of a capital lease to noodle on-

• The ownership of the asset is shifted from the lessor to the lessee (you) by the end of the lease period; or

• The lessee (you) can buy the asset from the lessor at the end of the lease term for a below-market price; or

• The period of the lease encompasses at least 75% of the useful life of the asset (and the lease is non-cancellable during that time); or

• The present value of the minimum lease payments required under the lease is at least 90% of the fair value of the asset at the inception of the lease.

Note all the “or’s”. Again, don’t get too caught up in the technicalities. Just understand that you might have a capital lease that needs further investigation and special handling for your accounting records. Operating leases are simple and deducted in their entirety (such as office rent). Here is the link to the IRS Publication 535 (Business Expenses)–

wcginc.com/5334

One final word; under GAAP accounting, the rules are different for those who are required to follow special accounting procedures. Here is a blurb from RSM (a big fancy accounting and auditing firm) that explains it a bit-

Under the old guidance (ASC 840), operating leases were not recorded on the balance sheet, but under ASC 842 operating leases are required to be recorded on the balance sheet, which results in the addition of more assets and liabilities on the balance sheet. Finance (capital) leases will continue to be recognized on the balance sheet. Certain types of assets are excluded from the new standard–leases relating to inventory, intangibles, and some natural resources. The recognition, measurement, and presentation of expenses and cash flows from a lease will continue to depend on its classification as a finance or operating lease. The classification criteria in ASC 842 does not impact the classification for most leases, however, the bright-line classification of ASC 840 was replaced with a principles-based approach.

Don’t get hung up on this. Most small businesses do not have a GAAP requirement… this news is just for gee-whiz cocktail conversation. The reason for all this? Operating leases are obligations that are not required to be presented on the balance sheet. An automobile lease here and there, no biggie. A fleet of Boeing 737s is certainly a different situation, and as an investor you would want to know the impact on the balance sheet from these legal obligations.