Manage Risk with Fixed Assets

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1 Manage Risk with Fixed Assets Presented by: V. Lynn Lambert, CPA Lambert Lanoue & Smoker LLC Outline Analysis of Lease vs Purchase of Fixed Assets New IRS Repair Regulations Capital Lease Operating Lease Capital Leases are considered a purchase of an asset and recognized as an asset with a corresponding liability on the balance sheet if any of the four criteria are met: Term exceeds 75% of the life of the asset Transfer of ownership at the end of the lease Payments exceed 90% of the fair market value of the asset over the life of the lease Bargain purchase is a condition at the end of the lease period Asset and liability is not recorded on the balance sheet. Annual lease payments are deducted on the income statement. Asset is returned to the lessor at the end of the lease. Qualitative Consideration of a Lease Qualitative - continued Expense annual lease payment for income tax purposes (operating lease) No down payment, security deposit or origination fees Generally lower fixed payments for the lease term Inflation Protection against obsolescence Impact on Balance Sheet Economic value of the asset at the end of lease A lease is a long-term legal obligation and generally you cannot cancel the lease agreement. Contract requirements that determine a lease to be a capital lease. 1

2 Discounted Cash Flow Analysis Net Cash Outlay & Present Value To analyze the cost differences between a lease vs a direct purchase of an assets, one must perform a discounted cash flow analysis. This analysis compares the cost of each alternative by considering: the timing of the payments, tax benefits, the interest rate on the loan, the lease rate, and other financial arrangements. Need to make certain assumptions about the economic life of the equipment, salvage value and depreciation. Net cash outlay IS NOT cash flow. Net cash outlay is annual lease payments less tax savings on the transaction. Each year s net cash outlay must be discounted to take into consideration the time value of money to determine the present value of each payment. The sum of the present value computations will determine the best financial option for the use of the asset. Fast Tools Spreadsheet Lease Data Input LEASE: Description of item Truck Cash downpayment/security deposit $1,500 Fixed cash lease payments per payment period $9,000 Length of lease contract (years) 3 Tax Deductible Yr.1 Prepaid Payments per year 1 Purchase option at end of lease * $20,000 Terminal value at the end of planning horizon $0 Effect of downpayment on lease payments No ef fect Return of downpayment/security deposit $0 Purchase Data Input Additional Data Input PURCHASE: Description of item Truck Purchase price (cash boot) $50,000 Terminal value at the end of planning horizon $0 Length to depreciate (years) 5 Depreciation method * MACRS (150%, half year) Section 179 election $0 Financing : Downpayment (% of purchase) 10% Length of loan (years) 5 Interest rate on loan 3.000% Payments per year 1 INVESTOR INFORMATION: Planning horizon (years) 5 Marginal income & SE tax rate 45% Tax rate on capital sale 30% After-tax discount rate 3.000% ITEM TRADED: Adjusted basis of traded or sold item $0 Years remaining depreciation on item traded 0 Number of additional items still being depreciated 0 Market value of traded item applied towards lease $0 ITEM SOLD FOR CASH: Cash received for item sold (not traded) $0 Applies to: Lease Purchase 2

3 Lease Analysis Purchase Analysis NPV Analysis Dow npayment/ Contractual Depreciation Net After Lease Security Lease Lease Payment Cash Lease Adjustment Terminal Expense After Tax Tax Discount Present Payment & Payments Adjustments Payments for Purchase Purchase Option Terminal Value Cash Flow Factor Value s Year Payment Period Refund Taxes & Trade Value -1, , , , , , , , , , , , , , , , , , , , , , , , , , , , NPV Analysis Credit Purchase End of Period Dow npayment Interest Depreciation After Tax Adjustment Net After Discount Present Loan and Loan Payment Expense Expense Terminal Value & for Tax Factor Value Year Balance Loan Balance Taxes Cash Flow s 0 45, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , Results New IRS Repair Regulations RESULTS: Present Value Purchase Outlfows $28, Present Value Lease Outflows $27, Under these terms, the lease is preferred by an amount equal to: $ Click to calculate items below Cash lease payments that would equate NPV $9, Original purchase price that would equate NPV $48, Effective January 1, 2014, IRS has issued complex tax regulations on the purchase and improvement of assets and property. To better understand the regulations, one must consider the initial proposition presented below: All tangible property that is not inventory, must be capitalized and depreciated unless there is an exception. Five Main Areas Materials and Supplies The IRS Comprehensive Repair and Capitalization Final Regulations address changes to the following areas: Materials & Supplies Repairs and Maintenance Capital Expenditures Acquisition and Production of Tangible Property Improvements of Tangible Property Materials and supplies items under $200 or has an economic useful life under 12 months, then the items can be expensed. Each business needs a capitalization policy. Accounting Method Change using form

4 Repairs & Maintenance Repairs Considered Improvements Make the annual De Minimis election to expense materials and repairs of $500 or under. Implement your capitalization policy by reviewing your repairs and expense items and determine whether they are repairs or need to be capitalized. Each business needs a capitalization policy. Betterment to the unit of property Restoration of the unit of property Adaptation of the unit of property If a repair meets one of these requirements, then the item must be capitalized. Betterments Restorations A repair that is considered a betterment must be capitalized under the following three tests: 1. Improves a condition or defect that existed prior to the acquisition of the property or production of the property. 2. Results in a material addition to the unit of property (expansion) 3. Results in material increase in the capacity, productivity, efficiency, strength or quality of unit of property or its output. Repairs that actually restore or built like new is considered a depreciable asset. Casualty losses are exempt under certain situations. Final regulations state that a generally comprehensive maintenance program conducted according to manufacturer s original specifications, even if substantial in nature, does not return a unit of property to a like-new condition. Adaptation Unit of Property Change the use of the unit of property in any form or nature will be considered a depreciable item and not a repair. A unit of property consists of a group of functionally interdependent components. Parts of a machine (engine, chassis, cab, etc.) are a unit of property for a truck. Floors, roofs, walls are a unit of property for a building. Major systems of building such as HVAC, plumbing, and electrical are considered separate units of property for capitalization purposes but remain part of unit of property of a building. Tile, culverts are considered a unit of property for a parcel of land. 4

5 Real Property - Buildings Partial Dispositions Safe Harbor rules for Small Taxpayer as defined with buildings unadjusted basis under $10 million and taxpayer s average annual gross receipts under $10 million can treat repairs as follows: No need to capitalize repairs, maintenance, improvements and similar activities so long as the cost does not exceed $10,000 or 2% of the unadjusted basis of the building. Under the new capitalization/repair regulations, an election can be made to take a loss on the disposal of a structural component. For example: When repairing a roof, a taxpayer can make an election to remove the original roof and take a loss on the remaining basis in the original cost of the roof. The issue is how to determine the cost of the original roof placed in service in Form 3115 Questions Report Method of Accounting Change to update and get depreciation schedules in compliance with the new capitalization and repair regulations Penalties for understatement of tax liability is 20%. After 2014 tax year, the cost file Form 3115 is $ Preparer penalties for failure to properly apply these new regulations. Thank You for Attending V. Lynn Lambert, CPA Lambert Lanoue & Smoker LLC La Porte Office Monticello Office llambert@lambertcpas.com 5