In our previous two blogs entitled “Tax Deductions Greater than Lease Payments?” and “How Section 179 Benefits Restaurants that Lease Equipment,” we examined how restaurants can save money by taking advantage of tax deductions from depreciation, and how the Section 179 deduction can provide a boon for restaurants that lease commercial kitchen equipment. In this, our final blog on the subject of depreciation, we’re going to delve deeper by considering the differences between capital versus operating leases and how the accounting under each can impact depreciation and tax deductions.
Basic Differences Explained
For accounting purposes a capital lease is treated like a loan, under which the lessee accounts for the asset as if it is owned. An operating lease considers lease payments as rental, with payments treated as operational expenses, and the asset is not claimed on the balance sheet. For tax purposes the biggest differences between the two are that:
- The underlying asset of a capital lease can be depreciated for tax deductions
- The lease payments for the underlying asset of an operational lease can offset income earned by the asset dollar for dollar as an operational expense
While both forms of leases provide tax deductions, the benefits of each are dependent upon a number of factors, including the asset’s estimated lifespan, terms of the lease, and the lessee’s overall tax situation, to name a few.
Operating Lease Advantages
- Lease payments are fully tax deductible as operational expenses
- Simpler accounting because asset is not put on balance sheet
- Asset obsolescence not a risk
- Provides flexibility to businesses that frequently update or replace equipment
- Greater Return on Asset without capital budgeting restraints
Capital Lease Advantages
- Quicker expense recognition than operating leases—whether by yearly depreciation or one-time Section 179 deduction
- Interest portion of lease treated as additional operational expense
Qualifying as a Capital Lease
Under standard accounting rules a lease can only be treated as a capital lease if it meets any one or more of the following criteria:
- Transfer of ownership to lessee at end of the lease term
- Includes “option to purchase” at a “bargain” price at end of term
- Lease term expected to exceed 75 percent of the life of the asset
- Payments must exceed 90 percent of asset’s fair market value
Leases not meeting any of these criteria must be treated as an operational lease. Leases that do meet the criteria can be treated as either a capital or operational lease.
How to Determine Which is More Beneficial
As suggested in the explanation of “basic differences,” a number of factors may influence whether a particular restaurant may accrue more benefits from a capital versus operational lease. The type of asset leased and the IRS’s determination of the asset’s expected life cycle play a large role. For example, if the IRS-established life span of a particular asset is expected to end before its entire value can be depreciated, it may be more advantageous to treat it as an operational lease and offset its operating expenses dollar for dollar. On the other hand, a start-up restaurant might want to make use of the one-time bang-for-the-buck provided by Section 197 by treating that same asset as a capital lease, which will also continue to provide it with interest payment expenses deductions.
Bottom line is that every restaurant needs to determine which accounting scenario provides the most cost savings in relation to its leased commercial kitchen equipment and overall tax situation.
The Restaurant Blog trusts that you’ve found this three-part series on depreciation and Section 179 to be informative and hopes that it may help your bottom line. As previously mentioned, please note that the information in this series does not constitute “tax advice,” but is simply an informative blog drafted in order to alert you of potential savings for restaurants within the tax code. Be sure to conduct due diligence by discussing your restaurant’s tax situation with a qualified accountant.Pages: