The business auto decision.Taxes and cash flows are the keys to finding the right vehicle.Acquiring a new auto is a major business expense. The decision is complicated by the variety of financing options available, as well as by a number of important tax considerations. To make the right decision, taxpayers will typically need to use discounted cash flow, particularly when choosing between leasing or buying. Since such analysis is generally beyond the scope of what most consumers and business owners can do, a CPA (Computer Press Association, Landing, NJ) An earlier membership organization founded in 1983 that promoted excellence in computer journalism. Its annual awards honored outstanding examples in print, broadcast and electronic media. The CPA disbanded in 2000. who is knowledgeable about discounted flow analysis and income tax matters will need to help the taxpayer make the best choice. It's appropriate to include a discussion of leasing vs. purchasing when CPAs meet with clients during the year to discuss tax minimization strategies--particularly if the client has never leased a vehicle before. This article discusses the information a CPA needs to consider when helping a self-employed client or employee lease or purchase a business auto. A lease/purchase spreadsheet spreadsheet Computer software that allows the user to enter columns and rows of numbers in a ledgerlike format. Any cell of the ledger may contain either data or a formula that describes the value that should be inserted therein based on the values in other cells. calculator calculator or calculating machine, device for performing numerical computations; it may be mechanical, electromechanical, or electronic. The electronic computer is also a calculator but performs other functions as well. designed by the authors is available free of charge at www.biz biz n. Informal Business. biz Noun Informal business Noun 1. .colostate.edu/faculty/cherieo/. It allows CPAs to compute To perform mathematical operations or general computer processing. For an explanation of "The 3 C's," or how the computer processes data, see computer. the aftertax net present value of both options. Simply click on the picture of the Lincoln Continental The Lincoln Continental, an automobile produced by the Lincoln division of Ford Motor Company, began for the 1939 model year. Over the next 63 years, despite these cars sharing under-pinnings with less expensive Ford automobiles, Continental was usually a distinguishly-styled, on the author's Web site and save the file to a disk. THE SEARCH FOR INFORMATION Low interest rates and the ability to use the Internet Internet Publicly accessible computer network connecting many smaller networks from around the world. It grew out of a U.S. Defense Department program called ARPANET (Advanced Research Projects Agency Network), established in 1969 with connections between computers at the to comparison shop allow taxpayers to minimize the aftertax cost of operating a car. Many financing options are now available. In particular, lease contracts have become more flexible, expanding clients' options for acquiring a vehicle. (See "Buy or Lease: The Eternal Question, "JofA, Apr. 99, page 25.) Web sites let users shop online for a new vehicle and find a dealership willing to sell or lease at a quoted price. A number of popular auto Web sites (listed throughout this article) let the user specify the brand, model and options desired. The sites quote a manufacturer's or "sticker" price, an invoice An itemized statement or written account of goods sent to a purchaser or consignee by a vendor that indicates the quantity and price of each piece of merchandise shipped. A consular invoice is one used in foreign trade. or "dealer" price and your price--the amount the dealer is willing to accept for the vehicle from an online referral. In computing computing - computer monthly payment options, the user specifies the length of the lease or purchase loan and the down payment. If the consumer is buying the vehicle, the site provides the annual interest rate as well as the monthly payment. The lease option, however, provides the monthly payment but does not specify the interest/discount rate. If the user is shopping to find the smallest monthly payment, the lease option is very appealing, since it is usually significantly less than the loan payment. Example. Exhibit 1, page 67, shows a 2001 Lincoln Continental. If purchased with a $250 down payment and a 8.15% (APR) interest rate, the monthly payment is $762.65 over 60 months (see exhibit 2, page 67). Total principal and interest are $45,759. If leased with a $250 down payment, the monthly lease payment is $609.67. At the conclusion of the 60-month lease, a lease termination fee termination fee The one-time charge for terminating or transferring an individual retirement account. If a financial institution charges a termination fee, the fee must be spelled out in the original agreement that is signed when the account is opened. of $350 is due. The total amount paid under the lease option is $36,930--more than $8,800 less than if the vehicle were purchased. [Exhibits 1-2 ILLUSTRATION OMITTED] At the end of the lease term, assuming the vehicle is in good condition and the consumer has not exceeded the mileage allowance Mileage Allowance A deduction of automobile expenses for people using their vehicles for business, charity, moving, medical or any other purpose that qualifies for a deduction. (ranging from 12,000 to 18,000 miles annually), he or she can simply return the vehicle to the dealer. In this case, the lessee One who rents real property or Personal Property from another. A lessee of land is a tenant. Cross-references Landlord and Tenant. lessee n. the person renting property under a written lease from the owner (lessor). spent less money but has no right to the vehicle at the end of the lease. By taking advantage of the standard purchase option--such as the one Lincoln Lincoln, city and district, England Lincoln, city (1991 pop. 79,980) and district, Lincolnshire, E England, in the Parts of Kesteven, on the Witham River. offers--the lessee can buy the Continental at its preestablished residual value Residual value Usually refers to the value of a lessor's property at the time the lease expires. residual value The price at which a fixed asset is expected to be sold at the end of its useful life. of $10,326.25. The lessee ultimately pays a total of $46,906--$1,147 more than under the purchase option. Of course, total dollars spent are not a valid means of comparison because the timing of the payments differs between the two alternatives. As explained below, discounted cash flow analysis adjusts for this difference. Neither the Web nor a quick visit to the local car dealer will provide all of the necessary information. Complex lease contracts combined with hidden costs complicate com·pli·cate tr. & intr.v. com·pli·cat·ed, com·pli·cat·ing, com·pli·cates 1. To make or become complex or perplexing. 2. To twist or become twisted together. adj. 1. the decision to lease or buy. For example, leases usually do not explicitly state the interest/discount rate; purchase contracts do. The lessor One who rents real property or Personal Property to another. A lessor of land is a landlord. Cross-references Landlord and Tenant. lessor n. the owner of real property who rents it to a lessee pursuant to a written lease. knows these rates, but they are usually not negotiable NEGOTIABLE. That which is capable of being transferred by assignment; a thing, the title to which may be transferred by a sale and indorsement or delivery. 2. to any significant extent. On the other hand, residual value (the amount the dealer is willing to accept for the vehicle at the end of the lease) typically is negotiable. A dealer who is motivated mo·ti·vate tr.v. mo·ti·vat·ed, mo·ti·vat·ing, mo·ti·vates To provide with an incentive; move to action; impel. mo to complete a lease transaction and "close the deal" may be willing to negotiate the auto's residual value to a higher level than its historic resale resale n. selling again, particularly at retail. In many states a "resale license" or "resale number" is required so that the state can monitor the collection of sales tax on retail sales. RESALE. value, thus reducing the lessee's monthly payment. A lessee who returns the auto in good condition at the end of the lease will have no further obligations, except perhaps a small disposition fee. A high residual value is the primary reason why many luxury auto manufacturers are able to offer unexpectedly low monthly lease payments. An awareness of these factors can help a CPA negotiate a more favorable fa·vor·a·ble adj. 1. Advantageous; helpful: favorable winds. 2. Encouraging; propitious: a favorable diagnosis. 3. lease for a client or employer. TAX CONSIDERATIONS Taxpayers engaged in a trade or business--including business entities, the self-employed and in some cases employees--may receive significant tax savings from business use of an auto because they can deduct de·duct v. de·duct·ed, de·duct·ing, de·ducts v.tr. 1. To take away (a quantity) from another; subtract. 2. To derive by deduction; deduce. v.intr. such expenses when computing taxable income Under the federal tax law, gross income reduced by adjustments and allowable deductions. It is the income against which tax rates are applied to compute an individual or entity's tax liability. The essence of taxable income is the accrual of some gain, profit, or benefit to a taxpayer. . For the self-employed, the tax savings include not only income tax savings, which could be as high as 39.6%, but also self-employment tax Self-Employment Tax A tax imposed on self-employed people, who must pay this tax in order to receive social-security benefits upon retirement. Notes: The self-employment tax may be reduced if the person also pays social security and Medicare taxes through another employer. savings, ranging from 2.9% to 15.3%. Taxpayers may elect to use the standard mileage MILEAGE. A compensation allowed by law to officers, for their trouble and expenses in travelling on public business. 2. The mileage allowed to members of congress, is eight dollars for every twenty miles of estimated distance, by the most usual roads, from his deduction deduction, in logic, form of inference such that the conclusion must be true if the premises are true. For example, if we know that all men have two legs and that John is a man, it is then logical to deduce that John has two legs. (32.5 cents per mile for tax year 2000, 34.5 cents for 2001), or they may choose the "actual expense" method. The IRC (Internet Relay Chat) Computer conferencing on the Internet. There are hundreds of IRC channels on numerous subjects that are hosted on IRC servers around the world. After joining a channel, your messages are broadcast to everyone listening to that channel. limits actual expenses such as gasoline gasoline or petrol, light, volatile mixture of hydrocarbons for use in the internal-combustion engine and as an organic solvent, obtained primarily by fractional distillation and "cracking" of petroleum, but also obtained from natural gas, by , tires, repairs, oil changes, insurance and licenses to the vehicle's business-use percentage. Interest expense on a purchased auto is deductible That which may be taken away or subtracted. In taxation, an item that may be subtracted from gross income or adjusted gross income in determining taxable income (e.g., interest expenses, charitable contributions, certain taxes). as trade or business expense. Depreciation. The actual expense method allows a taxpayer to claim a depreciation deduction, also limited by the business-use percentage. The depreciable depreciable Of, relating to, or being a long-term tangible asset that is subject to depreciation. basis of an auto is its purchase price, plus sales/use tax, less cash rebates, multiplied mul·ti·ply 1 v. mul·ti·plied, mul·ti·ply·ing, mul·ti·plies v.tr. 1. To increase the amount, number, or degree of. 2. Mathematics To perform multiplication on. by the business-use percentage ($20,000 purchase price plus $1,200 sales tax sales tax, levy on the sale of goods or services, generally calculated as a percentage of the selling price, and sometimes called a purchase tax. It is usually collected in the form of an extra charge by the retailer, who remits the tax to the government. minus $2,000 rebate rebate, partial refund of the total price paid for goods or services. In the United States, rebates were historically given by railroads to favored shippers as a return on transportation charges. times 75% business use percentage equals $14,400 depreciable basis.) Since 1984, federal tax laws have significantly reduced the depreciation deduction for business autos and have imposed stringent substantiation requirements. The depreciation deduction is limited for "luxury" autos rated at an unloaded gross auto weight of 6,000 pounds or less. For autos placed in service in calendar year 2000, the depreciation deduction limitation amounts IRC section 280F imposes are found in exhibit 3, at right (2001 limits are not available at the time of this writing). The applicable limits, as specified by section 280F, are determined for the year the auto is placed in service. For an auto used at least 50% for business, the depreciation deduction is based on the business-use percentage multiplied by the section 280F dollar limitations on annual depreciation. Once they are determined, the taxpayer must use these depreciation limits over the life of the auto. Exhibit 3: Depreciation and Lease Limits IRC section 280F Depreciation Limits for 2000 Year 1 Limit $3,060.00 Year 2 Limit $4,900.00 Year 3 Limit $2,950.00 Year 4 Limit $1,775.00 Year 5 Limit $1,775.00 Year 6 Limit $1,775.00 Dollar amounts for autos (partial table) with lease term beginning in calendar year 2000 Fair market value 5th and of auto 1st 2nd 3rd 4th later year Over Not over 20,000 20,500 41 91 133 160 85 20,500 21,000 45 100 147 176 204 21,000 21,500 50 109 160 193 222 21,500 22,000 54 118 174 209 241 22,000 23,000 60 132 194 234 269 23,000 24,000 68 150 222 266 306 24,000 25,000 77 168 249 298 345 25,000 26,000 85 187 276 331 381 26,000 27,000 93 205 303 364 419 27,000 28,000 102 223 330 396 457 28,000 29,000 110 241 358 429 494 29,000 30,000 119 259 385 461 532 30,000 31,000 127 278 412 493 570 31,000 32,000 135 296 439 527 607 32,000 33,000 144 314 467 558 645 33,000 34,000 152 333 493 591 683 34,000 35,000 160 351 521 623 720 35,000 36,000 169 369 548 656 757 36,000 37,000 177 388 574 689 795 37,000 38,000 185 406 602 721 833 38,000 39,000 194 424 629 754 870 39,000 40,000 202 443 656 786 908 Source: Revenue procedure 2000-18, IRB IRB See: Industrial Revenue Bond 2000-9, 722, February 27, 2000. Example. On January 2, 2000, George purchased and put into service a passenger vehicle. The maximum annual depreciation is $3,060. During the year George used the vehicle 75% for business. His maximum depreciation deduction is $2,295 [$3,060 x 0.75]. This limitation is a significant disadvantage to some taxpayers. While purporting to apply to "luxury" autos, it actually limits depreciation on any vehicle costing more than $15,300--well below any reasonable definition of luxury. While supposedly indexed for inflation, the section 280F limit has not nearly kept up with auto price increases. For example, according to according to prep. 1. As stated or indicated by; on the authority of: according to historians. 2. In keeping with: according to instructions. 3. U.S. Department of Energy statistics, the average price of a new car in the United States United States, officially United States of America, republic (2005 est. pop. 295,734,000), 3,539,227 sq mi (9,166,598 sq km), North America. The United States is the world's third largest country in population and the fourth largest country in area. rose 38.7% from 1987 to 1996, while the section 280F limit rose only 19.5%. Leasing. Although Congress intended that auto lease transactions be treated similarly to purchase transactions, leasing may have some inherent advantages. In general, a taxpayer who leases a business-use auto can claim a greater annual tax deduction Tax deduction An expense that a taxpayer is allowed to deduct from taxable income. tax deduction See deduction. . The law allows either the standard mileage or the actual expense method for leased autos. As with the purchase option, taxpayers must allocate To reserve a resource such as memory or disk. See memory allocation. expenses between business and personal use, and only the business portion is deductible. Similar to the depreciation limitations for purchased autos, section 280F(c) also requires an additional amount be included in income if the leased auto's fair market value is greater than $15,500, for tax year 2000. This effectively reduces the tax deduction for the lease payments and is intended to be substantially equivalent to the depreciation limitations imposed on owners. Temporary regulations section 1.280F-7(a) requires the lessee to include in gross income an annual inclusion amount determined from an IRS An abbreviation for the Internal Revenue Service, a federal agency charged with the responsibility of administering and enforcing internal revenue laws. table, part of which is reproduced in exhibit 3. Example. On January 2, 2000, Sue leased a car with a fair market value of $24,500. The dollar amount for an auto with a fair market value between $24,000 and $25,000 is $77. The qualified business use is 75%. The lease inclusion amount is $58 [$77 x 0.75]. The taxpayer must report this amount either on Form 2106, Employee Business Expenses or on line 6 of Schedule C, Profit or Loss from Business. In most states, leasing has a sales tax advantage. Sales tax is payable periodically as lease payments are made, rather than up front, as is the case with a purchase. Thus, the present value of sales taxes paid under the lease alternative is less than the sales tax paid when buying a car. THE RULES FOR EMPLOYEES An employee with unreimbursed business auto expenses must use form 2106 to claim an auto expense deduction. Any interest an employee pays on an auto loan is considered not to be trade or business interest, and is usually not deductible under the consumer interest rules. Because the total expense a taxpayer claims on form 2106 is also subject to the 2%-of-AGI limit for miscellaneous itemized deductions Itemized Deduction A deduction from a taxpayer's taxable adjusted gross income that is made up of deductions for money spent on certain goods and services throughout the year. , no tax benefit is likely to result unless an employee has other unreimbursed business expenses. In that case, leasing is usually preferable since it has the smallest negative cash flow before considering any tax savings. SPREADSHEET CALCULATOR We designed our lease-vs.-purchase spreadsheet calculator to help CPAs compute the net present value of the aftertax cost of leasing or purchasing a business-use auto for three, four or five years. The calculator incorporates section 280F depreciation limitations and lease inclusion amounts for a vehicle put into service during the 2000 tax year. Based on user-provided data, the spreadsheet calculates the monthly payments under the purchase option, including sales/use taxes, and the cash outflow and tax savings for each year. Likewise, the calculator computes the cash outflow and tax savings for each year under the lease option. The calculator then computes the aftertax present value of the net cash flows for each year and finds the total, aftertax present value of the net cash flows under both the purchase and the lease options, for either an employee or a self-employed taxpayer. CPAs enter the marginal tax rate Marginal Tax Rate The amount of tax paid on an additional dollar of income. As income rises, so does the tax rate. Notes: Many believe this discourages business investment because you are taking away the incentive to work harder. , including federal income taxes, self-employment taxes and state income taxes. If the employee does not expect to have other unreimbursed employee business expenses greater than 2% of AGI (Artificial General Intelligence) A machine intelligence that resembles that of a human being. Considered impossible by many, most artificial intelligence (AI) research, projects and products deal with specific applications such as industrial robots, playing chess, , the marginal tax rate is set at 0%. The purchase option assumes the auto is sold at the end of the period for its residual value. Finally, the calculator subtracts the net aftertax present value of the lease option net cash flows from the purchase option to determine the most beneficial alternative. LEASE VS. PURCHASE EXAMPLE Exhibit 4, at left, shows how to use the calculator to decide whether to lease or buy. The example relies on the same basic facts as exhibit 2. In addition, information on sales/use taxes, the qualified business use percentage, employment status and the marginal tax rate are incorporated into the decision making process. Based on this information, the spreadsheet calculator indicates that purchasing is preferable, saving the taxpayer $2,168 over the five-year holding period (see exhibit 5, page 72). Exhibit 4: Lease or Buy-Input Range Instructions: You may find information about leasing or purchasing an auto from one of these sites. www.carpoint.msn.com www.autogiant.com www.carsdirect.com www.driveoff.com www.leaseguide.com www.carinfo.com www.leasespy.com Input variables General Information: Employee or self-employed (1 or 2) 2 Monthly payments in year 1 12 Marginal tax rate 39% Sales/Use tax 7.05% Qualified business use % 80% Discount rate 8% Purchase Information: Purchase price, before sales/use taxes $37,730 Downpayment $ 250 Interest rate, if financed 8.15% Number of monthly loan payments 60 Lease information: Number of monthly payments 60 Fair market value $37,730 Monthly payment, before sales/use tax $ 609.67 Downpayment $ 250 Residual value/Trade-in allowance $10,326.25 Lease termination fee $350 [Exhibit 5 ILLUSTRATION OMITTED] Exhibit 6, page 72, shows the results of a sensitivity analysis that CPAs can perform with the spreadsheet calculator. It includes five different scenarios. In scenario 1, the auto is either leased or purchased over 60 months. In scenarios 2 and 3, the auto is held for 60 months but the loan is for either 48 or 36 months. Thus the taxpayer has one or two years of ownership in which he or she makes no car payments. In scenarios 4 and 5, the lease and purchase terms are equal for either a 48- or a 36-month holding period. The monthly car payments, lease payments and residual values are given for each scenario. The taxpayer is assumed to be an employee who does not have unreimbursed employee business expenses greater than 2% of AGI (marginal tax rate = 0%), an employee who does have such unreimbursed expenses (marginal tax rate = 24%) or self-employed (marginal tax rate = 39%). [Exhibit 6 ILLUSTRATION OMITTED] Leasing is the dominant strategy for employees because cash outflows are lower and tax savings result only if the employee has other unreimbursed business expenses exceeding 2% of AGI. Purchasing is preferable when the auto is paid off rapidly--keeping interest costs low--and retained for five years or more. Purchasing also is the dominant strategy for the self-employed, except for shorter-term acquisitions. Caution: While these results are typical, altering the fact pattern will cause them to vary. CPAs should enter each fact pattern into the spreadsheet for separate analysis. A COMPLEX DECISION The lease-purchase decision is made even more complex because of the section 280F depreciation limitations and lease inclusion amounts, which severely limit the depreciation deduction for a business-use auto. Widely varying contract terms, especially for leases, also complicate the decision. While one can draw some general conclusions regarding whether to lease or purchase a business auto (see exhibit 7, above), CPAs need to independently investigate each situation. Our spreadsheet calculator is a useful tool for this purpose. Because autos are expensive, the decision is often material to a client or employer, providing CPAs with an opportunity to provide a valuable service.
Exhibit 7: Rules of Thumb--When to Do What
When to Buy When to Lease
Purchaser pays cash rather Lessee wants lower monthly
than financing payments
Purchaser plans to hold auto Lessee plans frequent
for more than four years, trade-ins.
Auto weighs more than 6,000 lbs. Auto weighs less than 6,000
lbs. and costs more than
$15,300.
Purchaser plans high mileage Lessee plans low mileage
usage (more than 18,000 usage (less than 15,000
miles/year). miles/year).
Car Shopping on the Web More than half (54%) of all new vehicle buyers turn to the Internet for help when shopping for a new car--up from 40% in 1999. According to the J.D. Power and Associates 2000 New Autoshopper.com Study, the primary reason people shop online for a new vehicle is to find price-related information to help them negotiate with dealers. Among other survey findings * Kelley Blue Book (www.KBB KBB Kelley Blue Book KBB Koninklijke Bijenkorf Beheer KBB Kulak Burun Bogaz (Turkish: Ear, Nose & Throat) KBB Kelly Bell Band KBB Kim Basinger Band KBB Kentucky Backroads Band (band) .com) was the most frequently visited site for those seeking vehicle information. * 4.7% of all new vehicles were sold through an online buying service, up from 2.7% in 1999. * The most popular Internet new vehicle buying service was www.Autoby-tel.com, followed by www.CarPoint.msn.com and www.CarsDirect.com. * Audi buyers are the most likely to turn to the Internet for shopping help, with 81% seeking assistance. By comparison, only 38% of Buick buyers go online. Source: J.D. Power and Associates, Agoura Hills, California For the unincorporated community, see . Agoura Hills is a city (incorporated in 1982) in Los Angeles County, California, and has the ZIP code 91301. The population was 20,537 at the 2000 census. This city on the Ventura Freeway (U.S. , www.jdpa.com EXECUTIVE SUMMARY * THE DECISION TO BUY OR LEASE A BUSINESS AUTO is complex, complicated by both tax and cash flow considerations. Making the right choice is easier if a CPA uses discounted cash flow analysis to compare the available options. * CAR BUYERS CAN RESEARCH THE MANY FINANCING options on the Internet. A wide variety of Web sites are available to help consumers find the right model and understand the lease vs. purchase options. The authors have created a spreadsheet calculator, available online at www.biz.colostate.edu/faculty/cherieo/ to help CPAs compute the aftertax net present value of both options. * TAXPAYERS ENGAGED IN A TRADE OR BUSINESS are eligible for significant tax savings from the business use of an auto. Deductions are limited by the so-called business-use percentage. Depreciation also is limited for certain "luxury" vehicles. In general, a taxpayer who leases a business-use auto can claim a greater annual tax deduction. * USING THE AUTHORS' SPREADSHEET CALCULATOR, CPAs can compute the net present value of the aftertax cost of leasing or buying a business-use auto for three, four or five years. The calculator factors in tax and other information to help determine which option is better when the vehicle will be used for a deductible business purpose. * WIDELY VARYING CONTRACT TERMS MAKE THE LEASE vs. purchase decision even more difficult. For this reason it is difficult to make general rules; CPAs need to independently investigate each situation before making a recommendation to a client. [Exibit 2 ILLUSTRATION OMITTED] CHERIE O'NEIL, CPA, PhD, is professor of accounting at Colorado State University Colorado State University, at Fort Collins; land-grant with state and federal support; chartered 1870, opened 1879 as an agricultural college, assumed present name in 1957. There is a veterinary teaching hospital, an agricultural campus, and a research campus. in Fort Collins. Her e-mail address See Internet address. e-mail address - electronic mail address is cherie.oneil@mail.biz.colostate.edu. DONALD SAMELSON CPA, Phi), is associate professor of accounting at Colorado State University. His e-mail address is don.samelson@mail.biz.colostate.edu. MATTHEW R. WILLS is a staff accountant with Arthur Andersen For the U.S. Supreme Court case commonly known as Arthur Andersen, see . Arthur Andersen LLP, based in Chicago, was once one of the "Big Five" accounting firms (the other four are PricewaterhouseCoopers, Deloitte Touche Tohmatsu, Ernst & Young and KPMG), performing & Co. in Denver. His e-mail address is Matthew.R.Wills@US.ArthurAndersen.com. |
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