Critical Considerations When Leasing or Buying Equipment

Equipment is a major part of some contractors’ job costs. Should you lease it, or should you buy it? Which is better for you? The answer is, it depends. We’re helping you decipher the question and sharing some additional equipment considerations on this week’s episode.

Topics we cover in this episode include:

  • Operating Lease vs. Capital Lease
  • Consider the costs associated with maintaining the equipment you own
  • Insurance costs and considerations for equipment
  • Equipment and vandalism
  • How to decide whether to purchase or lease a piece of equipment
  • Benefits and drawbacks of having a separate company to own your equipment

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Wade Carpenter, CPA, CGMA | CarpenterCPAs.com
Stephen Brown, Bonding Expert | SuretyAnswers.com

TRANSCRIPT

[00:00:00] Wade Carpenter: Equipment is a major part of some contractors’ job costs. Should you lease it, or should you buy it? Which is better for you? The answer is, it depends. Come on in. Let’s talk about it. This is the Contractor Success Forum.

If you’re new here, I’m Wade Carpenter with Carpenter Company CPAs. With me, my co host, Stephen Brown with McDaniel Whitley Bonding and Insurance. Stephen, initial thoughts to start us off?

[00:00:28] Stephen Brown: It’s a big issue. How does it, how do you make a decision whether to lease or purchase equipment? And you’re going to hear a lot of things from a lot of people about what you should do. And if you know all the facts, I think you and your accountant can make a good decision.

[00:00:44] Wade Carpenter: And sometimes you may be trying to make some decision based on what a salesman tells you as well. So sometimes you need to understand all the angles of it. So any thoughts on where you want to start this one?

[00:00:56] Stephen Brown: Yeah equipment is something that, you know, it’s exciting to me. I love seeing a new piece of equipment. It’s exciting. It makes your work a lot easier. It is vital to the construction industry. And having good operators, making sure that equipment is in good operating condition, that it’s insured properly that it’s working when you need it to work.

These are all important things. But you also have to tie in the cost of that equipment in your job costs. So, how’s the best way to tie in the best job costs, I would think would be the key factor to consider. I know emotionally you want to own that equipment. And by owning that equipment, you build up the net worth of your company by owning it versus leasing it or renting it.

But at the same time, unfortunately, that equity that you have in your equipment is not really being considered by bonding companies as far as working capital credit. And the same banks might more easily lend you money based on the fair market value of the equipment that you own that you don’t have any debt on.

So, what do you do Wade, when one of your clients comes to you and they’re trying to decide what to do?

[00:02:08] Wade Carpenter: Well, there’s a lot of factors I think we can probably talk about here, definitely. And, some of it is the cash flow. One of the biggest things is the cash flow, whether it’s the initial cost or the long term effect of it. And I think we also should kick around short term rentals versus longer term rentals. And there’s, like I said, typically a lease would be a lower up front cost versus maybe a higher down payment when you’re buying it. But it depends.

The long term cash flow, a lot of times, you’re spreading out a payment over the long term, but if you’re buying it, you’re thinking I’m going to own this at the end and I won’t have payments and everything will be a lot cheaper.

But again, we’ve talked about this many times. I had a lot of heavy equipment guys get stuck with their pants down in 2008. And if that $100,000 plus piece of equipment is sitting idle, it’s not making you money. It’s just costing you cash flow.

[00:03:04] Stephen Brown: That’s right. And most big contractors have their own mechanics. And in the past, equipment was a lot easier to rebuild and replace.

Now with all the computer systems and everything in the equipment, dealers are making it harder for you to work on their equipment. And in the farm industry especially. For example, John Deere, absolutely positively has to work on the equipment or it voids all the warranty.

And even if you wanted to work on it yourself, you couldn’t get the parts and you don’t know how to fix it. That’s a stressful situation for contractors. I see a lot of older equipment that’s being rebuilt is really worth more now. Folks want to own something that they can fix themselves.

[00:03:48] Wade Carpenter: A lot of the other people think about the tax deductibility of it, and that’s 1 of the biggest questions I get as well. And, typically you have a lease that’s an operating lease where we’re going to have payments as we go, and we’re going to be. deducting that as we go versus buying the equipment.

You can buy that equipment and maybe didn’t make your own down payment, but have a whole bunch of payments in the future and get your deduction up front. And we talked about some of the evils of that from a pros and cons I should say, because a lot of times we don’t want to, we want to defer that tax as much as we can, but we also, you know, contractors just hate paying taxes.

[00:04:30] Stephen Brown: Right.

Operating Lease vs. Capital Lease

[00:04:31] Wade Carpenter: One of the things I want to discuss is, you’ve really got to watch whether, I said operating lease versus capital lease, and the difference is more or less, do you own it, or have you basically used the economic life of that thing, or you could buy it out for a dollar at the end or whatever.

And some of those terms can be confusing, but the rules on that for tax as well as accounting rules, means that you can think it’s a lease, and you buy it at the end, but on your balance sheet, you got to treat it like you own it, and you got to treat it as a note payable.

So, trying to keep it off your balance sheet and keeping your debt down can backfire against you and hurt you on your bonding and banking.

[00:05:16] Stephen Brown: Well, so much of that has to depend on how much your taxes are estimated. But you may have deferred some income from one year into another year. You owe a whole lot of taxes. And the depreciation on that equipment in that upcoming tax year is It just flat out saves you what you were going to have to pay in in taxes.

How does that work, Wade?

[00:05:37] Wade Carpenter: Well, again, the, classic model is you go pay 10 percent down payment or even less, and then you get to deduct the whole thing up front and then you’re stuck with all these payments. And with 179 it takes a much larger contractor to be able to actually cap out on those those limits as long as you’ve got some profit. Most contractors can expense everything they want if they are owning it or would treat it as more of a capital lease where they own at the end.

[00:06:06] Stephen Brown: Okay.

[00:06:07] Wade Carpenter: But there is the balance sheet effect is whether, the bonding is going to give credit for, those fixed assets versus, you putting more of your liabilities and some of it’s going to be short term liability. It’s going to affect your working capital.

[00:06:21] Stephen Brown: Well, the reason the bonding companies don’t give you bonding credit for your equipment is because, one, they don’t understand the value of your equipment, market value. And second of all, the more equipment debt you have, the more it affects your cash flow and, and your working capital.

[00:06:40] Wade Carpenter: And I think most bonding companies don’t want to own that equipment if something goes wrong.

[00:06:44] Stephen Brown: That’s right.

Consider the costs associated with maintaining the equipment you own

[00:06:45] Wade Carpenter: One of the things I know me and you were kicking around when we were talking about this episode was. The cost of maintaining those that equipment if you own it versus the leasing and who, who bears the responsibility for repairing it.

So, can you talk about the maintenance?

[00:07:00] Stephen Brown: Sure. I, I have one client that, that rents all their equipment. because the, the, the rental company in, in his opinion, have the best mechanics. So everything to him is about keeping that equipment working. And he works also on military bases where your time frame to get the work done might be limited to base closures and so forth. So time is definitely money in that regard.

But he’s adamant that a good rental company will replace that equipment while they’re fixing the piece that they had rented you. Or they’ll have a mechanic out there with the capability of getting you up and running in a matter of hours instead of days.

That’s their thinking on it. And then historically speaking, the the road builders have more equipment. The dirt contractors have more equipment. Road builders have, equipment expense is such a key part of just getting started. And it’s just hard to compete with other larger asphalt contractors that have more equipment.

[00:08:06] Wade Carpenter: We talked about some of the nuances like, you know, maintaining it yourself versus having the equipment company take care of it as well as, are you going to hire that mechanic? Or if your machine breaks down, can you get that replacement? Because time is money and, every minute that’s down, it’s not making you money, and potentially causing you liquidated damages or something like that in the case of major delays.

Insurance costs and considerations for equipment

[00:08:32] Wade Carpenter: But can you throw in some stuff about the insurance and talking about some of those considerations from the costs and–

[00:08:39] Stephen Brown: Sure. When you rent equipment, you have an option of getting the equipment insured through the dealer or through your insurance agent. Your insurance agent has rented and leased equipment coverage on your policy. And the rate that’s charged for rental equipment through the insurance company when they write your other equipment coverages is a lot less than if you buy it through the dealer.

So a lot of folks will say, well, I’ll just buy it through the dealer. And if anything happens, I don’t have to worry about it. And that’s not always the case. Just like any policy, there’s a deductible. But rented and leased equipment coverage is based on the highest value you’re gonna rent.

So if you regularly rent equipment that’s a half a million dollars or less, and you have a half a million dollar limit on rented and leased equipment, and then at the end of the year, you pay a rate only based on how much you spent on rented equipment. It’s that simple. So it’s a whole lot easier and cost effective than getting it through the rental company.

And also, you can schedule the equipment that you own on your equipment policy. And I always tell people it’s important to schedule it for what it’s worth to you for replacement costs. So you might have an old piece of equipment that you completely rebuilt and you cannot replace that for X amount of money.

Then how much can you replace it for? So you put that value on the equipment and it’s your job as a contractor to tell your insurance agent how much you want on that equipment. And then, when there’s a claim, if the adjuster isn’t offering you as much as you had it insured for, then you have the right to argue with them why I insured it for this amount.

And you and your agent can go find other pieces of similar equipment around the country and go back to that adjuster and get more for the payment. So there’s a little bit of art to that too.

[00:10:32] Wade Carpenter: I can see that definitely, because I’ve had some contractors that, as you said put some major overhaul on that equipment, and it’s almost like brand new, but they never update that schedule. And then something happens to it, and I guess that sort of leads into something that we were kicking around as well from your insurance side.

Here in Atlanta, we’ve got a project going on for Atlanta has a, what they’re calling Cop City.

They’re building out a police thing, and there’s been a lot of protests, and a lot of contractors have actually gotten their equipment vandalized, and some of it destroyed. You got any thoughts on–

Equipment and vandalism

[00:11:07] Stephen Brown: Vandalism occurs more than thefts to equipment. Leave a piece of equipment out on a job site and, main vandalism things I see are besides just damage to the cab, breaking glass, so forth, it’s pouring stuff in your gas tank, it’s messing with your hydraulics it can be very expensive so I see that a lot.

I also wanted to say, back to what we were talking about before, when you’ve got an older piece of equipment that works great, and it just needs a new motor, it needs new tracks, it needs new this. That’s what most contractors are doing during the winter, during the downtime. They’re replacing that stuff. Then in the spring, when that equipment’s running hard again it’s up and ready to go. That’s just the way it is. So a lot of contractors build a lot of value. and old equipment by doing, by rebuilding the equipment themselves.

I have a wrecking contractor that just put $800,000 into one particular excavator over that particular issue. It wasn’t computerized.

[00:12:07] Wade Carpenter: Well, that was actually one of the things on my list because, we don’t really see equipment that goes out of date or obsolete or whatever, but a lot of times there are changes in technology and those kind of things that, pros and cons, I think when they break, as you were saying before. You got to have the dealer to fix it or you got to have somebody, versus the old motors and all this stuff we could all probably work on.

[00:12:29] Stephen Brown: Yeah, it’s just a big heap of scrap metal on your job site if it’s not working, that’s for sure.

How to decide whether to purchase or lease a piece of equipment

[00:12:34] Stephen Brown: But, Wade, let me ask you this. So, I’m deciding on whether to purchase or lease a piece of equipment. What kind of criteria do you need to use to evaluate whether you do one or the other?

[00:12:47] Wade Carpenter: Well, from my standpoint, they’re usually asking me about either the cash flow or the tax deductibility. And one of the things they a lot of times don’t think about too is things like sales tax. On a lease, you’re typically paying sales tax throughout versus when you buy it, you’ve got to pay all that sales tax up front.

And I’ll come back to that because a lot of people ask me about setting up a separate company for renting equipment. And I’d like to maybe address that. But a lot of times it’s a question of what’s the cash flow going to be like, and can I deduct this up front? And if deducting it up front, that’s sometimes all they think about.

It’s also, hey, I’m going to own this. And that’s desirable until you realize that number one, if something happens like 2008, then we’re going to be stuck with a lot of stuff. And. If you own it outright, that’s one thing, but if you’ve got a big old note that you’re going to be paying for another seven years, you’ve got a problem.

[00:13:43] Stephen Brown: Mm hmm. So back to what you said about a separate company to own the equipment. What would be the benefits and drawbacks of something like that?

Benefits and drawbacks of having a separate company to own your equipment

[00:13:53] Wade Carpenter: There’s pros and cons.

If your construction company gets sued for something, the thought is, hey, if I got the asset in a different company, I’m protecting it from that lawsuit. There’s also the thought of, hey, I can rent it from one and maybe make it work out so I’ll make a little bit of money on the side or something like that.

And I brought up the sales tax thing, because I’ve had contractors where they take a bulldozer, excavator or something, and they’ll put it in these equipment rental companies. And believe it or not, you’re like business to business, you’re generating, sometimes generating sales tax, at least here in Georgia, just transferring it between companies.

But if you’re renting a piece of real estate, that is a passive rental income, unless you’re self renting and that gets into a different topic, like for your own building. But if you’re renting equipment from a separate company, that income that flows into that separate company, that is subject to self employment tax because it’s not passive income.

So a lot of the contractors will get something like that and they just set up an LLC and get the tax bite on, the self employment income on top of that. So a lot of times we’ll set up an S corporation for some of that. But there is a little bit of art form to that. And again, if there’s a lot of tangents, we could go all, a lot of times we’ll take an equipment company, if we’re going to do it, and have a different year end.

So we can work on some of the Tax deductions, and I don’t want to get too deep into that, but there is a little bit of art form to that as well.

[00:15:23] Stephen Brown: Okay. Well, thank you for that. Anything else that we needed to discuss on this subject that our listeners might want to hear?

[00:15:31] Wade Carpenter: The only other thing that I really didn’t discuss is the financing. Sometimes we can be a little bit more flexible on the leasing companies, if they’re going to own it. It depends. It really depends on what you need.

But, after 2008, I counsel people do you really need to own this? Or, it’s nice to say, hey, I’m going to have this and I can do this anytime I want, but is that going to be sitting there idle? What’s it going to do to your cash flow? What’s it going to do to your taxes? What’s it going to do to your balance sheet? There’s a lot of considerations, and I’m sure I probably confused more people than anything, but if nothing else, hopefully people understood that we need to consider all the factors before we just jump in and do something like that.

[00:16:13] Stephen Brown: Absolutely. And one of the most stressful part, besides leasing or purchasing, is just trying to analyze how long that equipment’s going to last.

[00:16:22] Wade Carpenter: Right.

[00:16:23] Stephen Brown: How long can you reasonably expect it? And, the salesman’s telling you one thing, you might have a friendly competitor advising you otherwise, or a mentor.

But again, that’s why so many dirt contractors, especially, they don’t like change in what they know works. They’re going to own it. But if they’re renting it, they’ll take a chance. So that’s another criteria. Well, thanks, Wade. I think we covered everything that I wanted to, and I hope this helped our listeners chew on a few things while they’re just trying to decide what to do with their equipment.

[00:16:56] Wade Carpenter: Right. That kind of brings back a lot of memories of contractors walking me around their yard proud of showing off that equipment. But at the end of the day, sometimes it’s what you bring home.

[00:17:06] Stephen Brown: It’s a little of both, you want to be proud of your company, you want to own assets, you want to own assets that produce income for you. And cash is an asset that produces income for you. So, that’s why we think about cash flow in there. Not to rain on anyone’s parade, we’re not giving one advice over the other, we’re just telling you what you need to consider, right?

Okay.

[00:17:29] Wade Carpenter: With that, we’ll go ahead and bring this one to a close. Thank you all for listening to Contractor Success Forum. Check out the show notes at Contractorsuccessforum.com or on the Carpenter CPA’s YouTube channel for more information. We would appreciate it if you consider subscribing and follow us every week as we post a new episode.

 We will look forward to seeing you on our next show.