PhilMur's thoughts on biz/tech/money/life

DISCLAIMER:  My opinions and advice presented here should be interpreted to apply to only the smallest of businesses — sole proprietorships and and businesses with no more than a couple of million in annual revenues.  Larger businesses very well may take an asset use or purchase strategy that makes use of leasing.  I have worked in financial management in businesses where leases were used and they are often appropriate.  The target audience of this post is so-called micro-businesses made up of minimal revenues and a small handful of employees.

“My small business should lease its vehicles, because there’s tax advantages… right?”

A friend recently made this comment to me — a guy with a successful small business, a good head for his trade and even a good business head on his shoulders.

My response? NO. WRONG. NO.   (Note: If you want to skip all of this and want the analysis spreadsheet, click here).

Leasing vehicles for small business use is a bad idea 99% of the time (if you’re dying to know about that 1% exception, send me an email).  I hope to explain why this myth exists, however, in this post. Leasing vehicles for personal use is ALWAYS a bad idea. Plenty has been written about that by Dave Ramsey and others, so I won’t elaborate, as I want to focus here on the misinformation related to use of leasing in a small business.

I have witnessed a number of friends and arms-length acquaintances function very differently (financially speaking) in their newly incorporated or organized start-up business than they functioned just weeks earlier as an individual or maybe even as a sole proprietor at the time. This happens because they subscribe into the thinking out there that goes something like this:

Running your own business is a big responsibility. Sure, what I do comes easy for me. And yes, I am just a 2-employee company. But now that I am running a business, I have to shun simplicity and do what “sophisticated” business people do – things like leasing my vehicles and equipment because it will help my tax bill, and taking my clients out for expensive lunches (because I can write off the expense, after all!).

The thinking that running your own business is a big responsibility is right-on.  But the big responsibility, in large part, has little to do with changing behaviors but more to do with staying even-headed and controlling your spending and purchases, especially early on — and so, as tempting as it is to tackle that second issue (about meal write-offs), I will restrain myself for now and focus on the leasing issue.

The core of my argument is this: financially stable people and families are usually that way because they spend less than they make by living according to a budget that allows for and even provides for some flexibility due to unexpected events through conservative estimates and short-term savings.  A business that wants to remain financially stable should essentially do the same.  In other words, you should make financial decisions in your small business in the very same, prudent way in which an individual who wishes to remain financially solvent and stable, personally, would do.

When tax or credit considerations and ramifications, whether legitimate or not, become the primary driving force behind your business decisions, you are losing focus in your business.  What is fun about discussing the particular issue at hand is that the tax consideration here is not even legitimate, as I said, 99% of the time.  (A quick note: any lease characterized as a “Capital Lease”, with a bargain purchase price at the end of the lease, for example, is treated just like a cash or financed purchase, not a lease.  The leases discussed here are Operating Leases, which would be the most common type of lease incurred at an automobile dealership).

So, let’s briefly dig into the details of this issue.

Point #1: If your business is not generating enough cash to allow you to save up and purchase the needed vehicle or asset in short order, then wait until you can, don’t lease or finance it!

Before we even talk about the tax issues involved, I feel it is important to point out that if your company cannot generate enough profits and cash on a monthly basis to buy one straight out, then I would not instead just buy a new vehicle on credit.  By avoiding the credit trap, you will keep the monthly expense burden your company has fairly low–which will keep things from getting stressful too quickly if your business drops off, even temporarily.  Consider buying a used one for an amount of money you can write a check for.  Besides, as you’ll see below, you do not lose any tax advantages by buying a used vehicle as compared to a new vehicle.

Point #2: Any time a seller of anything — furniture, real estate, vehicles, electronics, clothing, etc. — attaches special payment terms or credit advantages to a purchase, then BUYER BEWARE!

I don’t mean to imply that just because credit is being offered alongside a product, the product is somehow inferior or of poor quality.  Rather, I am warning you that you will probably pay too much for that item — definitely, if you take advantage of the “special terms”, and probably even if you don’t.  This is one reason that even if I have the cash to buy a new car personally or in a business setting, I am unlikely to do so unless I can buy it at a price that strips out most of the “instant” loss of value that typically would occur when you drive a new vehicle off of the dealer’s lot.

Car manufacturers and dealerships that push you hard towards a leasing arrangement almost certainly have a financial incentive to do so, or they believe that the leasing financing structure will be the easiest way to sell you the car – persuasively and financially speaking.

Unfortunately, as alluded to above, even if you turn away the offer of financing and can come up with the cash to buy the vehicle or asset on the spot, you will likely “pay” for the financing anyway, because the prices of items are naturally going to be higher when they are losing money or breaking even on a fancy financing arrangement.  So, keep that in mind as you negotiate even on a cash deal.

Point #3: Yes, you can deduct lease payments, thereby lowering your taxable income, but with a financed purchase or cash purchase situation, your deduction will often be significantly larger!

If you lease a vehicle, typically the lease payments will be a constant amount for some period of time, like 36 months.  If you purchase a vehicle on credit, the loan payments will likewise be constant for the term of the loan.  However, these costs are deducted from your income in different ways.

With a lease payment, your total payments for the year would be a deductible expense, i.e. if your lease payments are $300/month, then your total deductible lease costs for the year would be $3,600.

With a purchased vehicle, however, the interest expense on loan payments is deductible, and most importantly, you also deduct depreciation on the vehicle per the IRS’ defined depreciation rates.

As an example, let’s say you purchase a $20,000 vehicle with cash.  The first year, the IRS will let you deduct 20% of the value of the vehicle, and the second year you depreciate 32%.  The percentage goes down in the later years, and ultimately the vehicle is “fully depreciated” from a tax perspective at the end of its fifth year.  So, in our example your depreciation in year 1 would be $4,000, and then $6,400 in year two.  And, if you have chosen to finance it, those additional interest expense dollars during each year would be deductible as well.

And last but not least, there are special “accelerated” depreciation provisions in the tax code which allow a small business to write-off (deduct from its income) 100% of a purchased asset’s value in its first year, within certain limits.  This provision in the tax code is referred to as Section 179 Depreciation. So, just to be clear, if your small business purchases two assets during the year, for $20,000 each or for a total of $40,000, in most cases you are able to write off that entire amount from your taxes in the very first year! How’s that for a write-off!  You will never experience such a significant tax benefit in year 1 of a leasing structure!

Point #4: You are probably not in the habit of typically paying much more for something than necessary just to obtain a possible small tax benefit

Let’s think of a hypothetical scenario to illustrate what can often happen with vehicle purchases.  Imagine you go to Radio Shack (now just “The Shack”, have you heard??), looking to purchase an LCD TV and get out of the store having spent less than $500. They have the perfect unit for you– it’s $450 + sales tax of course, and it meets all of your criteria for what you want in a new TV. But before you can tell sales representative that you want it, they immediately point you to another unit for $600, identical in every way — the same features, quality, warranty, etc. However, they claim that due to a special loophole in sales tax law (I told you this was hypothetical), you would owe no sales tax on the $600 unit and so they claim that would be a better financial decision for you to make. So let’s do the math… $450 plus 8% sales tax, let’s say, so that would be about $486 in total… or you could select the $600 unit and pay $600 even.

Anyone knows that there is no reason to spend more than budgeted and more than was required to buy an identical unit just so you can escape some tax– it just doesn’t make up for the higher price of the tax-free unit!  And yet this is what many people have done recently thanks to the miserable “Cash for Clunkers” program–they bought new vehicles because it was “a good deal”, when their budgets and original plans may have been to buy a lower-end car, or a reliable used car.  Their decision was driven by the tax benefits they expected to realize.

A small business owner who leases a vehicle because of the supposed tax advantages associated with that lease is making no wiser of a decision than one who would buy the $600 TV, and no wiser a decision than the person who threw out their planned budget in order to take advantage of a tax credit via Cash for Clunkers.

Point #5: Do the Math and see for yourself!

So, here’s the nitty-gritty… we need to get into the math to prove my point.  But first, let’s understand exactly what happens with a lease offering made to you by a dealership:

1)  They entice you with small monthly lease payments, and a short term that lets you get a new vehicle only 36 months later!

2)  Because of the small monthly lease payment, they often require a substantial down payment of several thousand dollars– or your old vehicle as a trade-in to satisfy that up-front cost

3)  The dealership protects themselves against any excessive devaluation of the leased vehicle by tacking on hefty mileage fees over certain annual or lease-term mileage limits — after all, why would they want you to come out ahead in this deal, when they will own the vehicle the entire time and will want it worth as much as possible when it comes back to them?

4)  At the end of the day, the total cost of leasing a vehicle on a per-mile basis over 36 months, barring unforeseen drops in vehicle values or other unusual scenarios, will ALWAYS be more than the cost of owning the vehicle for that same period of time

So, even in cases where there is small tax advantage to be realized, the total net dollars you will spend at the end of the day in a lease arrangement will be higher. The proof is definitely in the numbers — but therein lies the problem: how does one compare the cost of leasing to the cost of buying with cash, or how does one compare the cost of leasing to the cost of buying with financing?

It requires a really fair, objective financial calculator that takes into account all costs incurred in a lease.  And unfortunately, there are few out there that are trustworthy and that accurately take into account lease down payments, the cost of mileage overages, and who take into account the loss of accelerated depreciation deductions when you instead opt for a lease.

One full-blown calculator I found is available only for purchase at a price of $129! That shows how out-of-reach these tools are to the average person about to purchase a vehicle.  (Keep reading, however, because I have created a tool you can download to help you run this analysis properly).

In fact, in my search to find a complete, accurate calculator online, I found more calculators designed specifically to promote leases than I found calculators with a fair, objective approach.  One example is the calculator found at http://www.leaseguide.com/leasevsbuy.htm .  Note that I’ve pasted a screenshot of the sample calculation image from their website below — you will see how even in their sample calculation they are deceiving consumers.

Note that they show a comparison of a 36-month lease to a 48-month car loan.  There are several problems with this– first of all, they should continue the lease to 48 months, or even more accurately, add another lease down payment and 12 months of a new lease to the first 36 months of cost, since presumably you would have to start another lease at the end of those 36 months.  Now, if you were using the calculator yourself you could rig it to analyze that issue properly, but by design the calculator would have you compare a shorter lease to a longer vehicle loan.  This is also one of the reasons why vehicle leases are only 36 months — they are more difficult to compare to a 4 or 5 year auto loan, and it stops the lease at a point where there is still some value for the dealer to recoup on their used car lot.

The second major issue with this calculator, and one that is built into the design of it, is that they do not take into account any initial lease down payment, which is required in practically every scenario.

Thirdly, you will notice they show a “lease residual of $15,300″ that would be owed at the end of the 36 months if you wished to keep the vehicle, however they do not include that in the total cost shown at the bottom.  If they did, you would see that the total cost of the leased vehicle would be more than the cost of the same vehicle if purchased.

Because of the lack of fair, complete calculators out there on the web, I have created a simple-to-use spreadsheet for small business owners to run the analysis on themselves.  Click here to download Phil’s Small Business Vehicle Lease vs. Buy Analysis Spreadsheet.

Or, if you don’t believe me or this spreadsheet, take it from true consumer advocate organizations like Consumer Reports or Dave Ramsey– in fact, the business vehicle leasing myth is one Dave highlights in his article entitled “Two Costly Tax Deduction Mistakes”.

In Conclusion, my point is this:  in the rare cases where a lease may give you a slight edge from a tax perspective for a year or two, you have still paid more for the right to lease the vehicle over the course of the lease than you would to have purchased it at a fair price.

Do NOT be fooled by the supposed tax advantages of leasing that are toted by vehicle manufacturers, dealerships, and in some cases, even your CPA or tax preparer.  In particular, if you do not understand the math behind each scenario, take the safe, tried-and-true route of saving up your money and buying a vehicle in cash.  And if you are set on purchasing before you have the cash for whatever reason, then please, please steer clear of the lease route, and instead do a straight purchase with traditional financing at the best purchase price and lowest interest rate possible.