Many companies choose to lease a piece of equipment instead of purchasing it outright. Leasing has several advantages over buying, but lease contracts also have legal provisions that require lessees to make payments regardless of the circumstances, whether internal or external.
Here's how equipment leasing works and the potential problems a lessee could have if unable to make the payments.
Video of the Day
What Is Leasing?
With a lease, you enter into an agreement with the lessor to rent the equipment and make payments for a certain period of time rather than purchasing. At the end of the lease, you'll have the option, depending on the type of lease, to either purchase the equipment or give it back to the lessor.
There are advantages of leases:
- low or no cash down payment
- freeing up funds that can be used for other capital needs
- less paperwork than getting approved for a loan
- no risk of obsolescence
- tax deductible
There are also disadvantages of leases:
- sometimes higher interest rates when compared to business loans to purchase equipment
- lessee responsible for maintenance of the equipment
- lessee required to make payments regardless of circumstances, whether internal or external
Consider also: Lenders That Pull Only Equifax Reports
Types of Equipment Leases
There are two types of equipment leases: a capital lease and an operating lease.
Capital lease – With a capital lease, the lessor receives all the benefits of ownership but also has all the obligations, such as maintenance. Capital leases are best for expensive equipment that the business wants to retain for the long term. The lessee records the equipment as an asset and the lease as a liability on their balance sheet, and treats the lease payments as a business expense and a tax deduction.
These leases also offer the lessee the option to purchase the equipment at the end of the lease period at fair market value or maybe even a bargain price, such as $1.
Operating lease – With operating leases, the leasing company is the owner of the equipment, and they absorb the risk of obsolescence. The business is simply renting the equipment. Operating leases are best for short-term periods of time and for equipment that needs frequent replacement due to obsolescence and technological advances. These types of leases may have renewal options.
Consider also: How to Create a Schedule of Capital Lease Payments
Although leasing has many advantages, leases can be difficult to get out of if the business experiences financial hardships, such as those that arose from the pandemic.
What Is the Hell or High Water Clause?
Government restrictions that arose from the COVID-19 pandemic have led many small business owners to close or severely limit their operations. As a result, these businesses ran into cash flow problems and had difficulty meeting their financial obligations, including leases.
These lessees have tried to invoke such defenses as force majeure and impossibility of performance in order to avoid making their lease payments. However, many lease agreements have a "hell or high water" clause, which means the lessees must meet their lease payment obligations, regardless of the cause.
Although lessees have challenged the enforceability of these clauses, courts have ruled that these clauses are legitimate and are essential to the well-being of the equipment financing industry. Therefore, it appears that lessees will be obligated to make their lease payments or incur late payment penalties, which can accumulate, and risk repossession of the leased equipment and possible confiscation of their personal assets, if they have personal guaranteed the equipment lease agreement.