Basic Leasing Terminology

Leases and rentals are contractual arrangements by which the owner of property (the "lessor") allows another person (the "lessee") to use the property for a stated period of time in exchange for cash payments or other compensation. There is no real legal distinction between a "lease" and a "rental." In practice, however, rentals generally are considered short-term arrangements (a day, a week, a month), while leases are arrangements for longer terms (a year or more).

Types of Leases

The two main types of equipment leases you'll encounter are "true" leases and "financial" leases. You also may hear about "sales and leaseback" leases, which in reality are sophisticated financing transactions.

True leases. If the lessee acquires no rights to the property other than its use, then the lease is commonly referred to as a "true" (or "straight") lease. Under a true lease, the lessor is treated as the owner of the leased property for both tax and non-tax purposes, and the lessee's rental payments do not establish any equity in the property. A true lease usually gives the lessee the option to prematurely end the lease, subject to conditions that are spelled out in the agreement.

If the lessor remains responsible for maintaining the property, then a true lease also may be referred to as an "operating" (or "maintenance") lease.

Financial leases. A lease that is used to effectively finance the purchase of assets is commonly referred to as a "financial" (or "financing" or "finance") lease. The distinguishing characteristics of financial leases are that (1) the duration of the lease generally coincides with the functional or economic life of the property, (2) the lease may not be canceled, and (3) the lessee is responsible for maintaining the property. Frequently, a financial lease will be structured so that the lessee's only practical choice at the end of the lease is to purchase the asset. For example, the parties may agree at the inception of the lease that the lessee will purchase the asset for a specified price (this type of lease is effectively a conditional sales agreement). Or perhaps the lease gives the lessor the right to compel the lessee to purchase the asset or provides the lessee the option to purchase the property for a nominal price.

For accounting and tax purposes, financial leases are generally treated as a sale.

Sale and leaseback leases. Under a "sale and leaseback" arrangement, the owner of an asset sells the asset to a third party and then immediately leases it back. The benefit of this transaction is that the owner frees up the cash that was tied up in the asset (through the sale) while still retaining its use (through the leaseback).

To a large extent, your expected need for the leased equipment will determine whether you end up with a true lease or a financial lease. If you expect to need the equipment for most, if not all, of its useful life, then you'll probably end up with a financial lease. In contrast, if you expect that you'll need only the equipment for a specified period and that the equipment will be of use to someone else at the end of that period, you probably can find a lessor who's willing to set you up with a true lease arrangement.

Key Lease Terms

Here are some of the major terms commonly found in equipment leases of which you should be aware:

• Lease term. Identifies how long the lease will be in effect. If you suspect that your need for the equipment may exceed the initial term, try negotiating the inclusion in the agreement of a renewal option that entitles you to renew the lease for a specified period or periods and for a specified rent.
• Rental rate. Identifies how much the rent is and when it must be paid. Most leases also include late payment provisions that impose an additional charge if you fail to pay the rent when it's due or within a specified grace period. If your business experiences seasonal or irregular sales activity, try negotiating a flexible rental rate that corresponds to the changes in your cash flow.

Save Money Although not always explicit in nature, the rental rate for equipment leases frequently has an interest component. Accordingly, when interest rates drop, lease payments may also drop on new equipment leases. Following an interest rate drop, check to see if your lease can be modified. If the lease cannot be modified due to an expensive cancellation provision, investigate buying out the lease with less costly bank financing.

• Maintenance. Identifies who is required to maintain the equipment. Be wary about accepting a requirement that you provide a higher degree of maintenance than would be required if you owned the equipment.
• Improvements and modifications. Identifies whether you have the right to make improvements or modifications to the equipment so that it better suits your needs. Depending on the equipment involved, you may want to specify who's responsible for modifications required by federal or state regulatory agencies.
• Insurance. Identifies who is required to insure the equipment, as well as who is entitled to what part of any settlement if the equipment is lost, stolen, or damaged.
• Stipulated losses. Specifies amounts you'll owe if the equipment is lost, stolen, or destroyed by casualty. Such amounts may be in addition to or in lieu of the value of the equipment.
• Purchase option. Identifies whether you'll have the right or obligation to purchase the equipment. The provision should specify an option price or range and how and when the option may be exercised.
• Transfers. Identifies whether you or the lessor has the right to transfer your respective interests in the lease. You want to be sure that a transfer by the lessor will in no way infringe upon your expectations under the lease. You'll also want to check under what conditions, if any, you'll be able to sublease the equipment to others.
• Claims. Identifies whether you can sue and take other actions in the lessor's name to assert claims against suppliers and others with respect to the equipment and whether you're entitled to retain any settlements from such actions.
• Early termination and amendment. Identifies under what conditions the lease may be amended or canceled. These provisions become more important as the term of the lease increases. Try to forecast the circumstances under which the equipment may become uneconomical or useless to you (for example, the adoption of a law that makes your use of the equipment illegal, a technological advancement that makes the equipment obsolete, etc.), then try to negotiate a provision that addresses those circumstances.
• Modern equipment substitution. Provides for updating the equipment or replacing it with a newer model during the lease term. This is an especially useful provision to have included in a lease for computer equipment, communications devices, and other items that are subject to rapid technological advancements.
• Termination costs. Identifies who is responsible for the costs (dismantling, packing, shipping, insurance, etc.) related to returning equipment to the lessor at the end of the lease term.
• Master lease. Identifies that additional equipment can be leased by an addendum to the agreement that describes the new equipment, the rental rate, and lease term. This type of provision can yield substantial savings in negotiation costs if you expect an ongoing relationship with the lessor.