The time is right

Ready to purchase capital equipment? Here are some financing options.

Upgrading capital equipment is high on the to-do list of many shops. Innovative financing packages and tax incentives certainly make this a buyer's market. However, many shops may be unaware of available financing options. Here's what they need to know to take advantage of these options and to slash the tax burden.

Buy or lease?
For small businesses needing to finance equipment, the best option — a loan or a lease — depends on the business' individual situation. Generally, the cost of leasing is comparable to that of other financing options, considering the entire transaction. But leases are not loans, and their costs are figured differently. Leases take into account the equipment has a residual value at the end of the lease term. Residuals are built into lease pricing, usually making lease payments lower than loan payments.

What is a loan? In a loan transaction, shops borrow money to pay for equipment while offering lenders a security interest in it. A shop owns the equipment and capitalizes the asset on its balance sheet. Depreciation and interest expense are accounted for on the profit-and-loss statement.

The most common loan is a fully amortized fixed-rate contract. The payments are the same throughout the term. The borrower owns the equipment once the payments are finished. Loans can be set with equal principal plus interest, where principal reduction is the same each month but monthly interest goes down over the term. Most banks and commercial-finance companies offer fully amortized fixed-rate loans for equipment acquisitions.

Another type is a floating-rate loan tied to one of several indexes and adjusted monthly or at the end of the term based on interest-rate fluctuations. This type of loan, offered primarily through a bank, is not common in commercial-finance transactions.

What is a lease? A lease is a contract in which one party conveys the right to use an asset to another party for a specified period in exchange for a specified number of payments. The type of lease best suited to a shop's needs depends on its equipment needs, business goals, and cash-flow requirements. For example, one shop may need a single piece of equipment requiring a single contract. Others may continually acquire equipment and exercise a master lease allowing for acquisition of many items within a single lease to avoid executing a new contract with each addition.

A $1.00-buyout lease provides the rights of ownership to the lessee. The asset is capitalized on the shop's books, allowing it to expense the depreciation and interest on its profit-and-loss statement. This structure requires the highest monthly payment over the term, and the shop then acquires the equipment for $1.00.

A finance lease, one of the common types, is a full-payout, noncancellable agreement in which the lessee is responsible for maintenance, taxes, and insurance. Finance leases are most attractive to shops that want the tax benefits of ownership or expect the equip-ment's residual value to be high. The benefit of this lease type is the advantage of the increase in current expensing under Section 179 of the tax code and the ability to expense to the amount allowed for the year the equipment is installed. These leases are structured as equipment-financing agreements with residuals set at some percentage of original equipment cost. The shop purchases the equipment at lease termination at a pre-agreed amount. The term of a finance lease tends to be longer than that of an operating lease, covering most of the equipment's useful life.

Another common lease is an operating lease, which is particularly attractive to shops that continually update or replace equipment, want to use equipment without owner-ship, and plan to return equipment at the end of the lease to avoid technological obsolescence. At the end of the term, the shop buys the equipment at its current fair-market value, returns the equipment, or renews the lease. An operating lease usually results in the lowest payment of any financing alternative and is a strategy for bypassing capital-budgeting restraints. This type typically qualifies for offbalance-sheet treatment and can improve return-on-investment due to a lower asset base.

A tax lease/purchase arrangement, a type of operating lease, is attractive to shops intending to buy the equipment. It establishes a midterm purchase-option price at a predetermined time so that a shop knows the cost of purchasing the equipment at a specific point in time. This eliminates the uncertainty of the purchase-option price being determined at the end of term.

Equipment sale-leasebacks allow shops of any size to raise quick capital. In a sale-leaseback, a shop sells some or all of its capital equipment or real estate to a leasing company and immediately leases back the asset. A sale-leaseback gives a business a cash infusion that can be used for any purpose. Shops taking advantage of this type of program typically believe the equity tied up in equipment can be better used elsewhere.

Refinancing existing debt is another alternative for shops looking to improve cash flow. In a declining interest-rate period, many companies refinance to lower interest rates. Usually, refinancing results in lower payments by extending the remaining term of the contract. Although refinancing results in more interest expense, the decreased payments let a shop borrow less short-term money to facilitate an expansion.

Some commercial finance companies, and manufacturers, offer machine-rental programs. The term of rental contracts can be as short as a few months or as long as a few years. At the end of the term, the shop has the option of buying the equipment, extending the rental period, returning the equipment, or in some cases, leasing it. Renting equipment is usually attractive to shops with a one-time contract or a job with a finite endpoint.

Choosing a financing option
When comparing loan versus leasing options, four factors should be considered in the decision making process: length of owner-ship, cash flow, ability to obtain financing, and tax incentives.

For long-term ownership, usually considered seven years or more, a loan is usually the best choice. The equipment is an asset and offers equity value. On the other hand, a lease may be better for short-term use — three years or less. With a lease, equipment can be easily upgraded to meet changing needs. This is often the case with technology equipment that depreciates rapidly or equipment needed on a project basis. Lease agreements can provide for the use of equipment for specific periods of time at fixed payments. The lessor assumes and manages the risk of equipment ownership. At the end of the lease, the lessor is responsible for disposition of the asset.

If useful equipment life falls between three and seven years, the decision is less straightforward and other factors, such as cash flow and the ability to get finaning, assume greater importance.

If the financing agreement is viewed as a short-term solution and the equipment will be paid off early, a loan is the best option. But if cash flow is tight, a lease may be the better option, even if long-term equipment ownership is planned. A lease requires no down payment, and soft costs — such as installation and training — may be included in the finance agreement.

Shops that lease equipment obtain an immediate write-off of the dollars spent. Leasing payments are considered expenses on the firm's balance sheet; therefore, equipment does not have to be depreciated over five to seven years. This provides immediate access to the equipment with little up-front investment.

A lease may be best for shops having difficulty obtaining equipment financing because of other needs. Leasing doesn't restrict the ability to obtain other financing because leased equipment doesn't have to show up on a balance sheet.

With both loans and capital leases, the equipment is depreciated as an asset. With all other lease options, up to 100% of the lease payment can be a pre-tax deduction.

The IRS does not consider an operating equipment lease to be a purchase, but rather a tax-deductible expense.

Read the fine print
It should go without saying, but before signing any financial-package contract, be sure to read it and understand its provisions. Problems can develop when oral agreements are made when negotiating the deal, but not included in the written contract. For example, some lessees may find that at the end of the lease period they owe more than they thought. Usually, this is the result of oral assurances from the lessor that are not reflected in the written lease contract.

Oral agreements can result from several situations. Sometimes, say people in the leasing business, a written option to buy equipment at the end of a lease, at a set price, can be a liability on the client's balance sheet. Some clients try to avoid this by having oral side agreements. In other cases, shops may assume a lessor is operating in good faith and not insist oral agreements be included in the contract.

Not understanding language in a contract can lead to problems. For example, one shop was led to believe it could purchase the equipment for $200,000 at the end of the lease. Language in the written contract stated at the lease expiration the shop could either sign a new lease or buy the equipment at a mutually agreeable price. If agreement on a buyout price could not be reached, the lessor could require the shop to rent the equipment for another year. The price agreeable to the lessor was over twice what the shop thought it would have to pay.

In such situations, the lessor usually points out that what was written in the contract is binding. The courts usually agree.

Equipment leases come in all shapes and sizes and need to be carefully examined and evaluated. Even firm purchase options (such as the option to purchase the equipment for $1.00 at expiration of the lease) must be reviewed to ensure they do not require prior written notice from the lessee to trigger the purchase option. Other aspects of leases that should be evaluated include interim-rent requirements that increase overall yield to the lessor, early termination provisions, and prepayment penalties.

Easing the tax burden
New machine tool technology that increases productivity and quality is essential to stay competitive in the world market. However, many shops find affording new technology a challenge. Although taxes are inevitable, several programs are available to shops to significantly reduce their impact. Recent changes in the tax code and segregating assets for tax purposes allow for accelerated depreciation and lower taxes. Where a shop is located can qualify it for many benefits, including tax incentives and credits, which mean more dollars to grow the business.

Feds give small businesses a break
ln May 2003, the Jobs and Economic Growth Act of 2003 was passed by Congress and signed by President Bush. The new tax act seeks to boost the U.S. economy by providing incentives to companies that invest in new technology and automation. Portions of the act are directly applicable to shops considering investment in capital equipment. The bill contains a new 50% expensing allowance for machine tools and other equipment ordered between May 6, 2003, and December 31, 2004, and placed in service by December 31, 2004. This replaces the temporary 30% expensing allowance enacted in 2002.

Small businesses with equipment purchases of $400,000, or less, get a first-year bonus depreciation of $100,000 under Section 179 of the tax code. Then, a business can take the new 50% expensing allowance on the remaining amount of equipment purchases. First-year asset-depreciation allowances also apply. Firms in the 7-year depreciation class can deduct 14% on the remaining balance; firms in the 5-year depreciation class can deduct 20%.

For example, a small business invests $200,000 in new CNC capital equipment. It can depreciate $100,000 under its first-year bonus allowance and take 50% off the remainder, bringing the book value down 75% to $50,000. Subtract another $7,143, assuming the shop is in the 7-year asset-depreciation class, and book value of the $200,000 equipment is now $42,857.

Seizing the opportunity
Companies are beginning to capitalize on this new small-business tax-incentive program. For example, Parker Precision Inc., Mentor, Ohio, is an eight-employee shop producing high-precision and quick-turnaround components and prototypes. Owner Reeve Parker jumped at the chance to increase productivity and output at a reduced cost. "The combination of reasonable interest rates and the new tax incentives helped me purchase seven new machines for the price of five," says Parker. "I can immediately reduce my customers' backlogs while running a more efficient operation that doesn't add significant costs. In this business, cash flow and monthly expenses are the difference between life and death. The tax incentives are great and, if everything works out, we'll do it again next year. We get the best of both worlds — more output with less overhead." Parker reports he is on track to double 2002 sales in 2003.

Another shop taking advantage of the new tax incentives is Metal Essence Inc. of Sanford, Fla. Employing 75 people manufacturing specialized metal parts for the automotive and aerospace industries, Metal Essence needed to upgrade equipment to stay ahead of fierce international competition. President Al Stimac said at a Capitol Hill news conference, "Thanks to the recent tax bills allowing small businesses to accelerate depreciation of new equipment, Metal Essence could afford to purchase a custom designed machine for over $800,000 in February, and two additional machines for about another $800,000, combined. The three new machines enable us to produce a particular auto part faster and more efficiently. I don't want to brag, but we're now able to beat prices of all international competitors. We're even receiving orders for Eastern Europe and Central America, where labor costs are generally much lower. The accelerated depreciation on these equipment purchases saved my company nearly $120,000 in tax liability. With improved cash flow and a projected annual growth rate pushing 20%, Metal Essence has purchased a new building and hired 23 new employees this year."

Financing help for small businesses
For a shop that qualifies as a small business, the Small Business Administration (SBA) offers several loan programs for expanding or acquiring equipment. The SBA defines a small business as "one that is independently owned and operated and which is not dominant in its field of operation." The SBA also established a table of size standards to qualify a concern as a small business, which is usually stated either as number of employ-ees or average annual receipts. Generally, a shop qualifies if it doesn't have more than 500 employees, or in some cases not more than 1,500.

Basic SBA 7(a) loan guaranty. This is the SBA's primary business loan and its most flexible program. Shops ineligible for business loans through normal lending channels may obtain financing through this program. Financing obtained through 7(a) can be used for a variety of business purposes, including acquisition of machines and equipment. Loan maturity is to 10 years for working capital and generally to 25 years for fixed assets.

Lenders who participate in the SBA program provide 7(a) loans. Not all lenders choose to participate, but most U. S. banks do. Lenders structure and administer their own loans and receive a guaranty from SBA on a portion of the loan.

Under the guaranty concept, a shop applies to a lender for financing, and the lender decides if it will make the loan normally or if the application has some weakness requiring an SBA guaranty. The SBA guaranty applies only to the lender; the borrower is obligated to the lender for the full amount of the loan.

Shops seeking financing must be aware of the lender's criteria and requirements, as well as those of the SBA. Under the 7(a) program, shops must meet the SBA size standards, be for-profit, not have internal business or personal resources to provide the financing, and demonstrate an ability to repay the loan.

CDCs: a key to SBA funding. Despite record-low-interest rates, many shops find it difficult to afford the funds to acquire the equipment and take advantage of recent tax cuts. However, the SBA's CDC/504 loan program provides long-term, fixed-rate financing for purchasing machinery and equipment. A Certified Development Company (CDC), covering a specific geographic area, is a nonprofit organization set up to foster the economic development of its area. CDCs work with lenders to provide financing to small businesses. Shops can borrow as much as 90% of a loan under this program. A private lender covers up to 50% of the loan, up to 40% is covered by a lien from a CDC backed by a 100% SBA-guaranteed debenture, and the shop seeking the loan contributes at least 10%.

The maximum SBA debenture is $1 million for meeting job-creation or community-development goals. Generally, a shop must create or retain one job for every $35,000 provided by the SBA. However, even if the equipment upgrade results in fewer employees, the shop may get credit for retained employ-ees and qualify for 504 financing if it shows the upgrade kept the shop from going out of business.

Under the 504 program, a shop qualifies as small if it does not have a tangible worth of more than $7 million and does not have an average income of more than $2.5 million after taxes for the preceding two years.

Loan prequalification. The SBA provides a loan-prequalification program that allows shops seeking loans of $250,000, or less, to have their applications analyzed and potentially sanctioned by the SBA before approaching a lender. The program focuses on an applicant's character, credit, experience, and reliability, rather than assets. The program is delivered through SBA-designated nonprofit intermediaries, such as small-business development centers and certified development companies, in specific geographic areas.

Dollars from your neighborhood
Depending on where a shop is located, it may qualify for a number of credits and tax incentives under a local enterprise-zone program. This frees up funds for other uses, such as purchasing machines or equipment. Enterprise zones are geographic areas that offer businesses within the zone various state and city tax incentives and other benefits. The purpose of these programs is to stimulate economic activity and revitalize declining geographic areas by encouraging retention and expansion of businesses. Shops that are expanding or moving into an enterprise zone can take advantage of these incentives. Enterprise-zone programs are available in most states; however, specific benefits, incentives, and qualifications vary from one zone to another.

Typical benefits and incentives include sales-tax exemption, property-tax reduction, finance assistance, real-estate tax exemption, utility-tax exemption, machinery and equipment sales-tax exemption, and job-creation tax credits. For example, one state offers an annual investment tax credit of 10% for the purchase of production property and equipment with a three-year 3% employment-incentive credit allowed for shops that increase employment. A wage-tax credit is available under this program for five consecutive years to shops hiring employees in newly created jobs. Companies moving to this state are entitled to a 50% cash refund for both the invest-ment-tax credit and wage-tax credit programs.

Accelerated depreciation of certain assets
Another way shops can save money to afford capital equipment is to take advantage of recent changes in the tax laws. Accelerating depreciation of the elements of a manufacturer's plant that qualify as personal property or land improvements can mean substantial tax deductions.

In the past, the IRS treated these individual elements as if all of the building and its contents had a business life of 39 years. A shop could spend a considerable amount on its building and land improvements and deduct only ¹ /39 of these costs per year .

Now, certain components of the building that qualify as personal property or land improvements can be depreciated separately. Landscaping and shrubbery have a 10-year-depreciation period and a parking lot a 15-year depreciation period. A shop can take, in a single year, the difference between the depreciation it took in the past and the depreciation now allowed. This could result in a considerable tax savings depending on a building's size, the makeup of a plant's components, and the length of time of ownership.