When it comes to truck acquisition strategies, one size does not fit all. There are several factors to consider, including vehicle replacement cycles, tax strategy, and corporate accounting, just to name a few. Even within the same fleet, some trucks are better suited for finance and others for lease, depending on the type of equipment upfits, special financing or leasing offers at time of acquisition, and anticipated mileage.
How should fleet managers determine whether to purchase, finance, or lease the next truck? What is the best way to discern which is the better deal?
Here's an overview of how each strategy works and the pros and cons of each to provide a guide to evaluating truck acquisition options.
Cash Purchase Options
Must cash be available to purchase a truck outright?
"Many small firms don't have the large amounts of cash needed for major capital acquisitions in the first place," said Ken Sibley, CPA, founder and managing director of Dallas-based accounting firm Sibley and Company. When cash is not an option, fleet managers look to financing or leasing to conserve cash and spread out truck payments on a monthly basis for a specified term.
If cash is available, what are advantages to purchasing trucks outright?
- Potential for lower acquisition cost. When a vehicle is financed or leased, interest charges, leasing fees, etc., are added to the vehicle's acquisition costs. When a fleet purchases a vehicle outright, those fees are not charged.
- Greater control over depreciation. Depreciation is the difference between the original purchase price and the proceeds received at vehicle resale. When a company owns a vehicle outright, it controls the resale pricing, with the potential to sell it at retail pricing versus wholesale.
- Lower insurance cost. With loans and leases, the bank or leasing company will require low insurance deductibles, from $250-$1,000, which can drive up insurance costs. When a company owns a vehicle outright, it controls what the deductibles will be. The higher the deductible, the lower the cost.
- Tax benefits. Vehicle purchases may qualify for bonus depreciation and/or IRS code Section 179 expensing. (See sidebar on page 28.) Consult the company's CPA for specific recommendations.
Is paying for a truck in full the best use of a company's cash?
"It really boils down to, 'If I don't use this cash for this purchase, what will I use it for? And what is the opportunity cost associated with that?' " said Mark Smith, strategic consulting services leader for GE Capital Fleet Services.
Sibley agrees. "A straight cash purchase using a firm's existing funds will almost always be more expensive than the lease or loan options because of the loss of use of funds."
How should a fleet determine whether or not to pay cash?
"When deciding whether to pay cash or borrow to purchase trucks, take the after-tax return on investment in the business and compare it to the after-tax cost of borrowing," explained Bill Smith, managing director, CBIZ MHM, a New York-based full-service certified public accounting and management consulting firm to Fortune 500 companies. "If a company earns 10-percent gross on whatever is pumped back into the business, and pays a 40-percent combined tax rate, the after-tax return is 6 percent. If borrowing at 10 percent and the company is able to deduct the amount, the after-tax cost is 6 percent. In this example, paying cash or borrowing is a 'wash' because it costs 6 percent to keep money out of the business and 6 percent to finance the trucks."
Therefore, the variables to plug into an analysis are the tax rate, gross profit, and borrowing cost (interest rate). If a company's after-tax profit is greater than the finance or lease cost (the cost of borrowing), then money produced by the business is best reinvested in the company.
Making a Finance Truck Purchase
What are the advantages of financing?
The finance option offers many of the same ownership benefits of the cash purchase, while conserving cash by providing the means to pay off the balance over time. Also, the purchase might qualify for tax savings from bonus depreciation and IRS code Section 179 expensing (see sidebar on page 28) without having to pay the full price of the equipment up-front.
What are the drawbacks to financing?
"The most obvious downside of [financing] versus leasing is the monthly payment, which is usually higher on a financed vehicle," said Sibley of Sibley and Company. "Also, the dealers usually require a reasonable down payment, so the initial out-of-pocket cost is higher when financing a vehicle compared to what's typically required for leasing."
Sibley also points to the potential of negative equity - if fleet intends to cycle out of the vehicle prior to the end of the loan term - as a significant drawback. "Presumably, as the vehicle loan is paid down, companies have the ability to build equity in the vehicle," Sibley said. "Unfortunately, this is not always the case. When purchasing a vehicle, the payments reflect the whole cost of the vehicle, usually amortized over a four- to six-year period. However, depreciation can take a nasty toll on a vehicle's value, especially in the first few years. As a result, buyers who put down modest down payments can end up financing a considerable portion of the vehicle and even find themselves in an 'upside-down situation,' in which the vehicle comes to be worth less than what the buyer stills owes on it at a given time."
How does this happen? Sibley explained: "Like the monthly payments of a mortgage, monthly vehicle payments are divided between paying principal and interest, and the amounts dedicated to each vary from payment to payment. In the first years in which a vehicle loan is paid back, the majority of each payment goes toward interest rather than principal. But in the first few years after being purchased, most new vehicles depreciate 20-40 percent. The loss in equity is a double whammy: the vehicle depreciates dramatically. Because the monthly payments have mostly gone toward interest rather than the principal, a company is left with very little equity in the vehicle."
The Truck Leasing Option
What are key differences between loans and leases?
"Leases and purchase loans are simply different methods of vehicle financing," explained Sibley of Sibley and Company. "[The lease] finances the use of a vehicle; [loans] finance the purchase of a vehicle."
In other words, a loan finances the total purchase price of the vehicle, including full sales tax, dealer fees, and tag and title fees, minus the down payment. A lease, in contrast, finances the spread between the vehicle purchase price, without sales tax included, and the residual (projected vehicle disposal) value at lease end. This spread represents the "use" or depreciation of the vehicle.
Therefore, if a truck costs $30,000 and the residual is set at $10,000 at the end of the lease term, essentially the company is financing the "use" - the difference, of $20,000 - instead of the full amount.
Unlike with a loan, when at the end of the term a company owns a vehicle outright, a number of scenarios should be considered at lease end. Depending on how the lease is structured, options may include purchasing the vehicle, turning it back in to the lessor, or trading it in on the acquisition of another vehicle.
What are the advantages of leasing?
"Perhaps the greatest benefit of leasing a vehicle is knowing exactly what the monthly cost will be when acquiring and maintaining the vehicle," said Sibley. "Leases may require a lower down payment and there are no up-front sales tax payments. Also, monthly payments are often lower [than comparable loans], and vehicles can be updated every few years."
According to Smith of GE Capital Fleet Services, "[Companies] don't have to come up with the entire amount up front and pay only for the amount used. They also get - in most states - rental tax treatment versus sales tax treatment [in which taxes are paid on the monthly rent payment, not sales tax on the full purchase price]."
"Leases are classified as either capital leases (off-book) or operating leases (off-book) from an accounting perspective based on how they are structured and if they pass the IRS requirements for operating leases," Smith noted. Companies should consult their own tax and accounting departments to ensure that their leases are being properly recorded.
Why is this relevant? It impacts debt-to-equity ratios when a company applies for business loans and other forms of financing. The "off-book" treatment for certain types of leases does not show as a liability on a balance sheet, which enhances the debt-to-equity ratio.
"Leasing also provides an alternative when financing the vehicle is not an option," Sibley said. "Many banks will not lend more than $30,000 for a vehicle loan. So, if a company plans to acquire a vehicle worth more than that, leasing may be the only option."
Leasing and Body-Build Time Considerations
"Often, when acquiring a medium-duty truck, a significant amount of upfitting can take place, which can take several months to complete," said Smith of GE Capital Fleet Services. "One advantage to leasing is that a company can finance that process and capitalize the cost of the finished asset over a period of time. Some of our customers with medium-duty truck applications might have an upfit period in excess of 12 months, as custom bodies are created. What we can do in that period is pay for the chassis and we charge an 'interest-only' scenario until the entire truck is built. Then, what we do is add the cost of the body to it, capitalize it, and begin depreciating it when the whole truck is ready. What this does is basically allow a company to defer the cost of the asset, and the cash flow associated with the asset, until it can go 'on-road' and begin generating revenue."
What are the Drawbacks of Leasing?
"By leasing a vehicle, a company always has a vehicle payment. If [a company] doesn't like that prospect, leasing is probably not right," said Sibley of Sibley and Company. "Also, if the vehicle will travel high miles during the year, consider instead a loan or an open-end lease. Most closed-end leases restrict mileage to 15,000 miles per year (sometimes even as low as 12,000 miles per year). If the allotted miles are exceeded, a company pays extra: the going rate is about 15-25 cents or more for every mile over the limit."
How does leasing impact insurance costs?
"Insurers usually charge higher coverage costs for leased vehicles. However, depending on driver age, driving record, and place of business, the additional cost may be nominal," Sibley said.
Sibley also advised: "When entering a lease agreement, be aware of any clauses in the contract regarding additional charges for 'excess wear and tear' or above-average costs for additional mileage. You want to minimize any surprise costs as much as possible."
Closed-end vs. Open-end Leases: What's the Difference?
"Closed-end leases allow a company to walk away from the vehicle at the end of the lease term. If the company owes for any mileage coverage or unusual wear and tear, this is when it would be paid for," said Sibley. "With an open-end lease - also known as an equity lease - the vehicle must be purchased at the end of the lease period for a predetermined amount. This is often the type of lease used by businesses or individuals who drive a lot."
Smith at GE Capital Fleet Services recommends that, for many commercial fleets, the open-end lease is a better fit because of the flexible terms and lack of mileage restrictions.
"Let's say a company leases a medium-duty truck on a closed-end lease," Smith posed. "If you signed up for a 12,000-mile-per-year lease, and the vehicle is only driven 8,000 miles, a company will have overpaid significantly for that lease. And, there's nothing that can be done about it. Or, if a company signed up for a 12,000-mile lease and ends up driving it 20,000 miles, it will be hammered with over-mileage fees."
"With the open-end lease, fleets reap the benefit of taking care of the vehicle and having less mileage on the vehicle rather than give that benefit to the leasing company," said Smith. "With an open-end lease you tell us what kind of an asset you want to drive (or we can help you select and design one) and we will set up the lease in a series of rental payments. At the end of the life of the vehicle, whether you choose to keep it three years, four, five, or whatever, we're going to sell the vehicle on your behalf. And if you overpaid your rental payments, we're going to give you a refund. If you underpaid, we're going to send you a bill for the difference. Either way, you have much more control.' "
Putting it All Together
Sibley of Sibley and Company poses a few questions to help fleet managers think through what's important in determining acquisition strategies:
- Is long-term cost savings more important than lower cash monthly payments? Advantage: Cash, Finance.
- Is having a new vehicle every two or three years with no major repair risks more important than long-term cost? Advantage: Leasing.
- Is having ownership in your vehicle more important than low up-front costs and no down payment? Advantage: Cash, Finance.
- Is the certainty of the vehicle's depreciation amount in a lease more important than the uncertainty of the residual value in a purchase/finance transaction? Advantage: Leasing.
- Is it important to pay off the vehicle and be debt-free for a while, even if it means higher monthly payments for the first few years? Advantage: Finance.
The Bottom Line
How does a company determine which strategy is right for its fleet? Know the objectives. Consider the impact of each strategy on cash flow, insurance costs, and taxes. Then consult a CPA, fleet management company, or other trusted business advisors for help structuring the vehicle acquisition strategy that best aligns with the company's operations.
What's the impact of bonus depreciation and IRS Code Section 179 on truck acquisitions?
Bill Smith, managing director, CBIZ MHM, a New York-based full-service certified public accounting and management consulting firm to Fortune 500 companies, offers this explanation.
"The 2010 Tax Relief Act enables taxpayers to deduct 100 percent of the cost of qualifying property (tangible personal property used in a trade or business, including trucks) placed in service between Sept. 9, 2010 and Dec. 31, 2011. For 2012 (and before Sept. 9, 2010), the bonus deprecation percentage is reduced to 50 percent. Bonus depreciation is only available for new property.
For 2011, Section 179 allows small businesses to elect to deduct the cost of qualifying property placed in service during the year rather than depreciate those costs over time. Under the Small Business Jobs Act, the maximum Section 179 deduction is $500,000, limited to taxable income, and is reduced by the amount the total eligible investment exceeds $2,000,000 ("phase out"). For 2012, the maximum is reduced to $125,000 and the phase out will start at $500,000. The Section 179 deduction applies to used property as well as new property."
What are the limitations, if any, of leasing and taking advantage of either bonus depreciation or Section 179 expensing?
According to Ken Sibley, CPA, founder and managing director of Dallas-based accounting firm Sibley and Company, "The lessee is not able to take direct advantage of bonus depreciation or Section 179 expensing; however, since the [leasing company] may be able to use these tax advantages, the indirect benefit could be reflected in a reduced lease cost."