cquiring 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 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 calculator designed by the authors is available free of charge at www.biz.colostate.edu/faculty/cherieo/. It allows CPAs to compute the aftertax net present value of both options. Simply click on the picture of the Lincoln Continental 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 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 or “dealer” price and your price—the amount the dealer is willing to accept for the vehicle from an online referral.
In computing 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 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 ). 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 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.
At the end of the lease term, assuming the vehicle is in good condition and the consumer has not exceeded the mileage allowance (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 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 offers—the lessee can buy the Continental at its preestablished residual value 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 the decision to lease or buy. For example, leases usually do not explicitly state the interest/discount rate; purchase contracts do. The lessor knows these rates, but they are usually not negotiable 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 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 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 lease for a client or employer.
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 such expenses when computing taxable income. 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 savings, ranging from 2.9% to 15.3%. Taxpayers may elect to use the standard mileage deduction (32.5 cents per mile for tax year 2000, 34.5 cents for 2001), or they may choose the “actual expense” method. The IRC limits actual expenses such as gasoline, tires, repairs, oil changes, insurance and licenses to the vehicle’s business-use percentage. Interest expense on a purchased auto is deductible 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 basis of an auto is its purchase price, plus sales/use tax, less cash rebates, multiplied by the business-use percentage ($20,000 purchase price plus $1,200 sales tax minus $2,000 rebate 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 (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.
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 U.S. Department of Energy statistics, the average price of a new car in the United States 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. The law allows either the standard mileage or the actual expense method for leased autos. As with the purchase option, taxpayers must allocate 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 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, 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.
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, 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, 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 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 ).
Exhibit 6 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%).
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 ), 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.