Bernie Buysitall and his partner Louis Leasumting became clients last year. They have a great operation consisting of 2,500 acres of cash crops in southern Manitoba. They have an informal partnership both reporting income on their personal tax returns. They have had the fortune of three great crops in a row and have prepaid their inputs for the upcoming year but still are faced with a significant tax problem.
Bernie and Louis need to put up some bins and also want to upgrade some machinery. Their problem is that while the bins and machinery require a significant capital investment they result in a very small tax deduction. The purchase, if not financed, will use up a significant portion of their cash which will limit them in terms of purchasing inputs to reduce their taxable position. Louis had the answer, “Let’s lease the bins and machinery so that we get a bigger tax deduction.”
Bernie was not convinced — he felt leases generally have a higher interest rate attached and he wondered about how they would get out of the lease if they needed to and the impact in the future of trading off a leased machine. Bernie and Louis came to us to nail down the impact of the two scenarios on their operation.
We began by updating their balance sheet and completed a projection for the upcoming year in a status quo scenario without any capital purchases. The balance sheet was strong with all liquidity and solvency ratios being strong. The income projection on a cash basis resulted in a net income after depreciation of $350,000. This split among Louis, Bernie and their wives resulted in a net income each of $87,500. The tax bill on such income would total about $100,000 — a number which both partners were not terribly excited about given that in 2011 they only got about 60 per cent of their acres seeded. Their accrued income for 2011 was projected to be significantly lower than in the past three years due to the unseeded acres.
The lease looked like a good option for solving the tax problem. A two year lease product was found that would allow the entire price of the bins and machinery purchases to be half written off in year one and the other half next year. Bernie’s concerns, however, still needed to be addressed.
LEASE RATES AND TERMS
Lease rates have decreased significantly in the past few years with lenders becoming more comfortable with this type of product. Some lenders fund leases off the bond market which is currently resulting in very low borrowing costs — currently under three per cent for a two year lease. Bernie’s primary concern of the cost of the lease seemed to be solved.
Bernie’s second concern revolved around the terms of the lease. He told us that when he was younger he had leased a truck and the payments were written off as a expense. His banker at the time was concerned with the operating expense ratio of his operation, as it was high in part due to the lease payments. The two year lease would result in a significant increase to the operating expenses of the operation, which he was concerned may limit their future borrowing capacity.
The need for good communication with your lender is critical in this type of situation. We explained to both Bernie and Louis and they would be building equity in the machinery and bins. This equity growth is a challenge to show on a balance sheet as in the interim of the lease there is no tangible asset that can be valued. In the case of a $100,000 bin purchase the initial $50,000 rental payment is made but is a expense for income tax. The asset, however is not owned until the final one dollar payment is made at the end of year two. It is critical and lenders are made aware of this situation as there will be significant residual value at the end of the lease. Bernie was also concerned about trading off equipment in the future. Will that result in capital gains in the future, he asked? It likely would, however if the next machine is leased the new lease payment should offset any recaptured depreciation that occurred.
In Bernie and Louis’s case they made a total lease payment of $200,000, and they had a $100,000 write off in year one which resulted in approximate tax savings of $36,756. “Nice,” said Louis with a big grin on his face. With Bernie’s concerns now addressed, he also had a look on his face, but it was a look of relief!
AndrewDeRuyckandMarkSloanemanagetwo farmingoperationsinsouthernManitobaandare partnersinRightChoiceManagementConsulting. Withover25yearsofcumulativeexperience, theyoffersupportinfarmmanagement,financial management,strategicplanningandmediation services.Theycanbereachedat [email protected] and [email protected] or204- 825-7392and204-825-8443