How to furnish your business with the necessary equipment can be a difficult decision. From a legal and financial perspective, the basic question is how to acquire the equipment. There are three basic options – buying it, leasing it, or leasing it under a so-called “finance lease.” For a variety of reasons, the option chosen can make a significant financial difference.
Buying the equipment is the most straightforward of the options. Your purchase gives you ownership of the equipment and, from a legal standpoint, this option gives you significant legal rights. Unfortunately, you will have paid the vendor the full purchase price for the equipment so you have no payments to “set off” if the equipment malfunctions. The best you can do under these circumstances would be to make a claim under the warranty, and many manufacturers’ warranties are limited in nature.
Conversely, a lease of the equipment does not give you ownership of the equipment, but it does provide certain other benefits. For example, if the equipment malfunctions, you, as lessee, have some leverage over the lessor in that you can simply stop paying (although, presumably, a lawsuit will soon follow); and, obviously, you would not have to borrow the purchase price or make the large initial outlay of money that accompanies a significant purchase.
The third basic form of transaction is the “finance lease,” also known as the “Article 2A lease” because it arises under Article 2A of the Uniform Commercial Code. This lease transaction is essentially a triangle between three parties, the vendor, a leasing company and yourself. In rough outline, you pick the equipment, the leasing company buys it from the vendor and you agree to make periodic payments to the leasing company for use and possession of the equipment. You then take delivery of the equipment, sign many papers, including an “acceptance” of the equipment, and begin paying monthly payments to the leasing company.
As long as the equipment works, everything is fine. However, if the equipment does not work, you have very little recourse. Regardless of how well or badly the equipment works, you have to pay the leasing company for equipment acquired under a finance lease. Under the “hell or high water” clause of §2A407 of the Uniform Commercial Code, your promise to pay becomes “irrevocable” and “independent” – meaning you must pay independent of whether the equipment works. You can bring a lawsuit against the vendor of the equipment, if you have succeeded to the rights of the leasing company under the many documents you signed. However, you have no warranties or other rights to enforce against the leasing company. Moreover, even if you sue the vendor you have to keep paying the leasing company. The reality of this arrangement is that as between you and the leasing company, a finance lease is not a lease, it is a loan, and you should expect to pay it.
This is a rough outline of the relevant legal framework. The reality is that the question of what a lessee or buyer’s legal rights are can become complex and the distinctions between the transactions often blur. Some transactions that call themselves “leases,” may be viewed as “disguised sales” by a judge. To complicate this, some transactions that are leases in the eyes of a state court judge may be a sale in the eyes of the Bankruptcy Court judge.
Additionally, there are tax considerations. The details of these go beyond the scope of this article, however, depending on the size of the acquisition, and the type of equipment, it can be better to lease than to buy for deductibility reasons. Last of all, there are “exit strategy” ramifications to how you have acquired the equipment if you intend to sell the business. From a financial standpoint, the buyer of the business may be allowed to assume the lease with the lessor’s permission. This results in no out of pocket money for the seller of the business. If the equipment was previously purchased by the seller of the business, and particularly if money was borrowed to buy the equipment, the equipment will likely be security for a loan and the balance would be paid by seller out of his sale proceeds.
Much can go wrong when acquiring equipment. Most equipment salesman, whether from a manufacturer or a leasing company, are paid on commission. Many of them give thorough financial analysis and advice, and many of them are entirely honest. However, their incentive is to close the transaction. In the event that you are pitched a lease or a finance lease for a significant piece of equipment, it’s beneficial to discuss the transaction with your accountant and/or lawyer.
– Rod Fluck