Equipment Leasing as a Current Financing Strategy for Middle Market Companies

The reasons a specific Lessee may choose to employ leasing as a financing strategy are numerous, however historic reasons can be categorized as follows:

• Facilitation of the acquisition, maintenance and replacement of equipment in a systematic way ' including the avoidance of stranded assets;
• Ability to have access to the latest equipment, or to acquire additional equipment or features ' promoting improved productivity;
• Share or transfer of technology risks associated with certain types of equipment ' protection against equipment obsolesce;
• Access to capital;
• Preservation of capital and credit facilities;
• Diversification of financing sources;
• Transfer needs from capital budget to operating budget ' and to assist in developing consistent expenses in budget planning process;
• Improved cash flow;
• Achieve desired financial results ' reduce reported debt levels, improve operating statistics at either parent or subsidiary/division level (both reported earnings and return on assets), management of debt covenants;
• Improved use of tax benefits ' exchanging tax benefits for lower rents, managing exposure to AMT and mid-quarter conventions, deductibility of rents;
• Cost benefit ' economies of scale in Lessor purchasing, servicing and asset redeployment services, and through decreased after-tax costs;
• Manage regulatory issues, including statutory capital for insurance companies and access to U.S. registered aircraft for foreign multinationals; and
• Flexibility and convenience.

It can be anticipated that many of the historic reasons listed above for a Lessee's use of leasing as a financing vehicle will remain relevant. However, as we consider the current environment, the following factors will further enhance leasing as a financing tool:

• Increased competitiveness of leasing v. debt financing as interest rates in the general economy rise;
• Increased exposure to Alternative Minimum Tax, especially for flow-through entities such as S-corporations, partnerships, and limited liability companies;
• Best use of tax benefits associated with equipment ownership – the corporate user, or a Lessor;
• Continued consolidation of commercial banks and the resulting contraction in (a) the number of sources, and (b) the amount of capital that may be available to a specific Lessee.

Interest Rates and the Increased Competitiveness of Leasing v. Debt Financing

Lease pricing, as compared to the pricing of equivalent term debt financing, is impacted by two factors: (a) the residual risk assumed by the Lessor; and (b) the multiplicative impact of (i) the deferral of taxes, and (ii) the time value of money. The level of residual risk assumed by the Lessor falls within the historic reasons that a Lessee may employ leasing and therefore will not be discussed here. The multiplicative impact of (i) the deferral of taxes, and (ii) the time value of money, however, are relevant to the issue of the impact interest rates in the general economy can have on the relative competitiveness of lease and debt financing.

Leases and loans are both comprised of a series of cash flows. With a loan, you have an interest component that is taxable to the lender, and a principal component that represents the lender's recovery of its investment. With a true lease, the entire rent stream is taxable to the Lessor, with its investment being recovered through the tax-depreciation of the equipment. It is the extent to which (a) the depreciation deductions available to a Lessor exceed the principal component of a loan, and (b) the time value of money, that a Lessor derives additional economic value (versus that which would be derived if the Lessor acting as a lender and in a debt financing) through the deferral of taxes that would have otherwise accrued on the receipt of the cash flows. And it is the creation of this economic value that enables a Lessor to offer improved pricing to a Lessee, versus the pricing the same Lessor, acting as a lender, could have offered a borrower in a debt financing (this comment ignores any residual risk assumed by the Lessor ' or stated otherwise, assumes that the residual risk assumed by the Lessor and any balloon associated with the debt financing are equal).

Charts 1 and 2, below, show investment-recovery curves for an asset (MACRS 3-year and 5-year property on Charts 1 and 2, respectively) for both a lease (the black curve) and a debt financing (the white curve). The term of both transactions is assumed to be 60 months commencing on July 1 of the initial tax year, causing each transaction to span 6 tax years. By definition, over the life of an asset, be it a leased asset or a loan, 100% of an asset's cost will be recovered such that the area under each respective curve is equal. However, depending on the MACRS class of the leased asset, and the assumed term of the debt financing, the shape and magnitude of each curve will differ.

[IMGCAP(2)]

[IMGCAP(3)]

As reflected in both charts, in the early years of each set of financing alternatives the depreciation deductions available to a Lessor exceed the amount of principal that would be recovered under an equivalent-term debt financing ' a situation that reverses itself in the later years. Likewise, the area representing the delta between the two curves prior to their point of intersection is equal to the area representing the delta between the two curves subsequent to their point of intersection, and sum to zero. The significance of these events is that while the same amount of taxes will be paid over the life of the lease (assuming stable tax rates), less taxable income (and even taxable losses) will accrue to a Lessor in the early years of the lease. This reduced level of taxable income results in taxes being deferred to the later years of the lease when the Lessor, as a result of the time value of money, will pay them with dollars having a lesser value than the same number of dollars would have today.

Chart 3, below, reflects the average annual 5-year treasury rate from 1990 to the current time and clearly reflects that general interest rates in the economy have trended downward through 2003. For the current year, however, interest rates have begun to turn around and most business leaders expect future interest rates to move in an upward direction. Opinions are many concerning how slowly or rapidly, and how far interest rates may move. However, it is significant to note that the average interest 5-year treasury rate in 1990 was 8.37%, and the median 5-year treasury rate since 1990 is 6.16%. Moreover, for the 9-year period 1992 through 2000 the average annual rate for the 5-year treasury traded in a 155 basis point range around a mean of 5.96%. These levels of interest rates compare to an average 5-year treasury rate of 2.97% and 3.35% for calendar year 2003 and the month of Oct. 2004, respectively. Clearly, there is a significant delta between the recent and current level of interest rates, and the trading range that existed during much of the 1990s.

[IMGCAP(4)]

Using the theory behind the time value of money, and constructs from the math of finance, we can analyze how the tax deferrals associated with leasing will impact the competitive position of leases v. debt financing assuming an interest rate market that varies from the current market. Specifically, the net present value (the “NPV”) of tax deferrals that exist in the early years of the lease, less the present value of tax payments that will be paid in the latter years of the lease, using a discount rate that is consistent with the anticipated levels of interest rates in the future market, will define the incremental value associated with leasing available to be passed through to the Lessee (assuming lease and debt yields are equivalent). These findings, which are solely related to the increased discount rate associated with a market characterized by higher interest rates, are found in Table 2, below.

[IMGCAP(5)]

The findings presented in Table 2 reflect that the value of tax benefits associated with leasing is dependent on the level of interest rates found in the market. At higher interest rates, the tax benefits associated with leasing have a greater value to a Lessor, and provide Lessors the ability to more competitively price their offering against debt financings targeting the same pretax returns. While the actual results are highly dependent on the specifics of a certain transaction ' including timing, transaction structure, and interest rates and yields associated with the risks defined by the customer and transaction ' the resulting position is that as interest rates rise (as well as targeted returns rise associated with transaction risks), Lessors have an ability to improve their comparative pricing against debt financings while maintaining an equivalent return.

Increased Exposure to the Alternative Minimum Tax

In 2000 13,135 corporations reported an Alternative Minimum Tax (AMT) liability totaling $3.9 billion ' representing a 27% increase from 1999. However, due to the lack of economic growth for 2001, the regular and alternative minimum tax bases declined resulting in 7101 corporations reporting a total AMT liability of $1.8 billion in 2001.

The Tax Reform Act of 1986 instituted the AMT as a tool to ensure that taxpayers paid a minimum amount of income tax in spite of legitimate use of exclusions, deductions and credits. For most of its existence the AMT has had a minimum effect on taxpayers, with less than 14,000 of the 5 million corporate tax returns filed in 2000 being subject to the AMT (2.8 million corporate tax returns reflected positive pretax earnings). However, for those corporations that are subject to the AMT, the increase in taxes over their regular tax liability can be serious; in fact, while the number of corporate taxpayers reporting a AMT liability declined by 13.4% in 2000, the amount of AMT liability reported by those corporations increased by 27%.

Corporations subject to the AMT have a right to claim a Minimum Tax Credit equal to the aggregate amount of all AMT paid for tax years beginning after 1986, less all Minimum Tax Credits already taken. Subject to certain rules, the Minimum Tax Credit can be used in subsequent years to reduce an entity's regular tax liability, but not below that of its tentative minimum tax. As such, the Minimum Tax Credit can only be claimed in years that the corporation has no AMT liability.

A review of corporate tax data available through the GAO and IRS suggests that between the years of 1987 and 2002 AMT liabilities exceeded the amount of Minimum Tax Credits claimed by nearly $20 billion (or 46.6%). For those taxpayers who can fully utilize their Minimum Tax Credits, the cost of the tax is equal to the time value of money associated with the early establishment of a tax liability through the AMT, a position supported by the work of Professor Andrew B. Lyon (University of Maryland) who has documented that firms undertaking investment in equipment while temporarily subject to the AMT generally face a higher cost of capital than firms that are only subject to the regular tax liability. For entities who must wait a long time to fully utilize their Minimum Tax Credits, or that are never able to utilize them, the resulting increase in their cost of capital can be substantial.

Entities that operate in industries characterized as being equipment intensive and as having low profit margins are considered to have a high propensity to become subject to the Alternative Minimum Tax (AMT) provisions of the U.S. Income Tax Code. While the depreciation adjustment (the difference between the amount of depreciation expense claimed by a taxpayer using the standard MACRS deduction, and the amount of depreciation expense derived using the 150% declining balance method) is just one of a set of adjustments and preferences that can subject a taxpayer to the AMT, it is through the leasing of assets (versus owning and depreciating assets) that an entity can minimize or eliminate the depreciation adjustment used to determine its Alternative Minimum Taxable Income, and ultimately its AMT.

With an improving economic climate, one would expect that tax liabilities ' under both the Regular and Alternative Minimum tax systems ' would increase. However, factors beyond the economy are at play here, including:

• Expiration of Bonus Depreciation rules will subject more equipment to the depreciation adjustment under the rules used to calculate AMT liability; and
• Projections concerning the AMT impact on individuals will have a similar, and possibly a greater impact on pass-through entities, including S corporations.

The bonus depreciation rules that have been in effect since the passage of the Economic Security and Recovery Act of 2001 (and subsequently, the Job Creation and Worker Assistance Act of 2002) have provided that equipment purchased and depreciated using the bonus depreciation rules was not subject to the depreciation adjustment rules under the AMT system. Effective Jan. 1, 2005 the bonus depreciation rules will expire for most types of equipment, and all equipment having a MACRS life of 3 through 10 years and depreciated using the Modified Accelerated Cost Recovery System will cause an adjustment to be made when determining AMT liability; specifically the difference in depreciation allowances using a 200% declining balance method (the MACRS method) and the AMT prescribed 150% declining balance method, will result in an adjustment for determining AMTI, and any resulting AMT liability.

In her 2003 report to Congress, Nina Olsen, the IRS's National Taxpayer Advocate, characterized the AMT as “the most serious problem faced by taxpayers.” While less than 1% of individual taxpayers have paid any AMT through 1999, in 2000 1 million taxpayers were subject to the tax, and 30 million taxpayers are expected to be subject to the tax in 2010. AMT receipts in 2010 are projected to total $90 billion, impacting 20% of all taxpayers, and 40% of all married couples. Further analysis indicates that two-thirds of taxpayers with an AGI between $50,000 and $100,000 will have an AMT liability; 90% of taxpayers with an AGI between $100,000 and $500,000 will have an AMT liability; and 30% of taxpayers with an AGI over $500,000 will be subject to the AMT in 2010. Taxpayers on the upper end of the income spectrum tend not have AMT liability because a large portion of their income is taxed at Regular tax rates that exceed AMT rates.

The projected increase in AMT exposure is, for the most part, attributable to inflation. The Regular tax system is indexed for inflation, but the AMT is not.

Certain business income is taxed at the individual level, including Schedule C and partnership income, as well as corporate profits of flow-through entities ' S Corporations and Regulated Investment Companies. For 2000 and 2001 flow-though corporate entities reported profits of $373 billion and $299 billion, respectively. It can reasonably be assumed that much of these profits will accrue to those taxpayers that will begin to see their AMT exposure rise through the end of the current decade.

In addition to subjecting a taxpayer to additional tax ' the AMT ' entities that find themselves in an AMT position need to adjust their assumptions when evaluating the lease v. purchase decision. When conducting a lease versus purchase analysis, expenses such as interest and depreciation have an after-tax cost equal to 1 minus the tax rate. For a C corporation in a 35% tax bracket, $500,000 of depreciation expense has an after-tax cost of $325,000 [$500,000 x (1 - 0.35) = $325,000]. However, the same C-Corporation when subject to AMT liability is now paying taxes at the corporate AMT rate of 20%, causing the true after-tax cost to increase to $400,000 [$500,000 x (1 - 0.20) = $400,000]. As such, any lease v. purchase analysis must use the AMT rate as the appropriate tax rates ' resulting in an increased cost of ownership. Note: For a flow-through entity, the analysis would use the individual AMT rates of 26% on the first $175,000 of AMT Taxable Income, and 28% on any AMT taxable income in excess of $175,000.

Best Use of Tax Benefits Associated with Equipment Ownership

As discussed in the section addressing interest rates and their impact on the relative competitiveness of leasing v. debt financing, leasing's economic value is, in part, associated with the Lessor's ability to defer taxes it may owe and then pay those taxes with discounted dollars. This is accomplished by using the depreciation associated with an asset to shelter revenue streams associated with that lease, as well as other revenue streams. The tax shelter associated with an expense is equal to the expense, times the taxpayer's marginal tax rate, which at the top corporate bracket is 35%. Therefore, an asset costing $1 million has the ability to shelter income equal to $350,000 [$1,000,000 x 0.35 = $350,000]. Most all Lessors assume a 35% federal tax rate, and some assume an additional state tax burden. If, however, the Lessor were only to have a 25% marginal tax rate, the tax shelter associated with the depreciation is reduced. Assuming the same $1 million asset, the asset has the ability to shelter income equal to $250,000 [$1,000,000 x 0.25 = $250,000].

The same is true for the user of the equipment considering a purchase. A corporation having income sufficient to place it in a 35% corporate tax bracket will have a higher utility for the depreciation associated with ownership and could use the depreciation to shelter income totaling $350,000. If, however, the equipment user were in a 25% tax bracket, the shelter would be reduced to $250,000. In either situation the corporation may elect lease financing for one reason or another, but in the case of the 25% taxpayer, management may find it advantageous to lease the asset from a Lessor that can more fully use the tax benefits, who passes his benefit through to the Lessee in the form of reduced rents.

Continued Consolidation of Providers of Capital (ie, the Commercial Banks)

Within the past year we have observed Bank of America purchase Fleet Boston; JP Morgan Chase purchase BankOne; and Wachovia purchase SouthTrust. These, and other corporate actions, represent a continuation of consolidation activities that occurred in the financial services industry over the past decade, and they can be expected to continue.

Every institution has lending limits. Consolidations seldom occur where the amount of credit available to a particular name equals to the sum of the exposures each institution had prior to the acquisition. Rather, exposure levels may have to be reduced, or future business may have to be reduced or syndicated. Equipment leasing companies have always served as an alternative source of capital, and will continue to do so.

Summary

In this article we have discussed leasing and the extent that it has been positioned as a financing tool for American business. We have briefly reviewed some of the historic reasons Lessees lease. We have also discussed a number of issues that are specific to the current environment that will most likely serve to further motivate additional leasing activity. However, leasing is not specifically dependent on an increasing interest rate environment, nor a continuation of consolidation among alternative providers of capital, nor an expansion of taxpayers subject to the AMT to maintain it market positioning. Lessees lease for a multitude of reasons ' both historic and evolving. It is true that the accounting framework may impact how certain leases are structured, and it is equally true that with the expiration of bonus depreciation lease rates will be increasing (but so will the after-tax cost of all forms of equipment ownership). It will be the understanding of a Lessee's needs, coupled with a willingness to solve financial and operational problems, that will allow Lessors to continue to provide Lessees with products that will serve as viable financing tools for both old and new reasons.

Equipment leasing remains a viable tool for middle market companies in today's environment. The Equipment Leasing Association of America (the “ELA”) estimates that of the $668 billion spent by U.S. business on productive assets in 2003, $208 billion, or 31.1%, was acquired through leasing, and for 2004 the ELA projects that leasing activity will grow to $218 billion, or 30.7 cents of every dollar American businesses will invest in equipment.

The leasing industry has a history of employing product and market strategies that meet changing customer needs and economic realities. As a result of these actions, the industry has established a relatively consistent market-penetration range ' 28% to 32% of annual business investment in equipment ( See Table 1, below), from which the industry's recent and anticipated performance has not deviated. While it is true that lease pricing will increase with the expiration of bonus depreciation, and accounting regulations may impose new rules that impact the financial reporting of lease obligations, many of the historical motivations to lease will remain, and new economic and environmental factors will drive the offering. This article will review some of the primary reasons why leasing has served as a relevant financing strategy through multiple business cycles and in light of changing customer needs. Moreover, we will identify some specific reasons why leasing will continue to serve as a valuable financing strategy for U.S. business: both middle market companies and larger companies, alike.

[IMGCAP(1)]

The reasons a specific Lessee may choose to employ leasing as a financing strategy are numerous, however historic reasons can be categorized as follows:

• Facilitation of the acquisition, maintenance and replacement of equipment in a systematic way ' including the avoidance of stranded assets;
• Ability to have access to the latest equipment, or to acquire additional equipment or features ' promoting improved productivity;
• Share or transfer of technology risks associated with certain types of equipment ' protection against equipment obsolesce;
• Access to capital;
• Preservation of capital and credit facilities;
• Diversification of financing sources;
• Transfer needs from capital budget to operating budget ' and to assist in developing consistent expenses in budget planning process;
• Improved cash flow;
• Achieve desired financial results ' reduce reported debt levels, improve operating statistics at either parent or subsidiary/division level (both reported earnings and return on assets), management of debt covenants;
• Improved use of tax benefits ' exchanging tax benefits for lower rents, managing exposure to AMT and mid-quarter conventions, deductibility of rents;
• Cost benefit ' economies of scale in Lessor purchasing, servicing and asset redeployment services, and through decreased after-tax costs;
• Manage regulatory issues, including statutory capital for insurance companies and access to U.S. registered aircraft for foreign multinationals; and
• Flexibility and convenience.

It can be anticipated that many of the historic reasons listed above for a Lessee's use of leasing as a financing vehicle will remain relevant. However, as we consider the current environment, the following factors will further enhance leasing as a financing tool:

• Increased competitiveness of leasing v. debt financing as interest rates in the general economy rise;
• Increased exposure to Alternative Minimum Tax, especially for flow-through entities such as S-corporations, partnerships, and limited liability companies;
• Best use of tax benefits associated with equipment ownership – the corporate user, or a Lessor;
• Continued consolidation of commercial banks and the resulting contraction in (a) the number of sources, and (b) the amount of capital that may be available to a specific Lessee.

Interest Rates and the Increased Competitiveness of Leasing v. Debt Financing

Lease pricing, as compared to the pricing of equivalent term debt financing, is impacted by two factors: (a) the residual risk assumed by the Lessor; and (b) the multiplicative impact of (i) the deferral of taxes, and (ii) the time value of money. The level of residual risk assumed by the Lessor falls within the historic reasons that a Lessee may employ leasing and therefore will not be discussed here. The multiplicative impact of (i) the deferral of taxes, and (ii) the time value of money, however, are relevant to the issue of the impact interest rates in the general economy can have on the relative competitiveness of lease and debt financing.

Leases and loans are both comprised of a series of cash flows. With a loan, you have an interest component that is taxable to the lender, and a principal component that represents the lender's recovery of its investment. With a true lease, the entire rent stream is taxable to the Lessor, with its investment being recovered through the tax-depreciation of the equipment. It is the extent to which (a) the depreciation deductions available to a Lessor exceed the principal component of a loan, and (b) the time value of money, that a Lessor derives additional economic value (versus that which would be derived if the Lessor acting as a lender and in a debt financing) through the deferral of taxes that would have otherwise accrued on the receipt of the cash flows. And it is the creation of this economic value that enables a Lessor to offer improved pricing to a Lessee, versus the pricing the same Lessor, acting as a lender, could have offered a borrower in a debt financing (this comment ignores any residual risk assumed by the Lessor ' or stated otherwise, assumes that the residual risk assumed by the Lessor and any balloon associated with the debt financing are equal).

Charts 1 and 2, below, show investment-recovery curves for an asset (MACRS 3-year and 5-year property on Charts 1 and 2, respectively) for both a lease (the black curve) and a debt financing (the white curve). The term of both transactions is assumed to be 60 months commencing on July 1 of the initial tax year, causing each transaction to span 6 tax years. By definition, over the life of an asset, be it a leased asset or a loan, 100% of an asset's cost will be recovered such that the area under each respective curve is equal. However, depending on the MACRS class of the leased asset, and the assumed term of the debt financing, the shape and magnitude of each curve will differ.

[IMGCAP(2)]

[IMGCAP(3)]

As reflected in both charts, in the early years of each set of financing alternatives the depreciation deductions available to a Lessor exceed the amount of principal that would be recovered under an equivalent-term debt financing ' a situation that reverses itself in the later years. Likewise, the area representing the delta between the two curves prior to their point of intersection is equal to the area representing the delta between the two curves subsequent to their point of intersection, and sum to zero. The significance of these events is that while the same amount of taxes will be paid over the life of the lease (assuming stable tax rates), less taxable income (and even taxable losses) will accrue to a Lessor in the early years of the lease. This reduced level of taxable income results in taxes being deferred to the later years of the lease when the Lessor, as a result of the time value of money, will pay them with dollars having a lesser value than the same number of dollars would have today.

Chart 3, below, reflects the average annual 5-year treasury rate from 1990 to the current time and clearly reflects that general interest rates in the economy have trended downward through 2003. For the current year, however, interest rates have begun to turn around and most business leaders expect future interest rates to move in an upward direction. Opinions are many concerning how slowly or rapidly, and how far interest rates may move. However, it is significant to note that the average interest 5-year treasury rate in 1990 was 8.37%, and the median 5-year treasury rate since 1990 is 6.16%. Moreover, for the 9-year period 1992 through 2000 the average annual rate for the 5-year treasury traded in a 155 basis point range around a mean of 5.96%. These levels of interest rates compare to an average 5-year treasury rate of 2.97% and 3.35% for calendar year 2003 and the month of Oct. 2004, respectively. Clearly, there is a significant delta between the recent and current level of interest rates, and the trading range that existed during much of the 1990s.

[IMGCAP(4)]

Using the theory behind the time value of money, and constructs from the math of finance, we can analyze how the tax deferrals associated with leasing will impact the competitive position of leases v. debt financing assuming an interest rate market that varies from the current market. Specifically, the net present value (the “NPV”) of tax deferrals that exist in the early years of the lease, less the present value of tax payments that will be paid in the latter years of the lease, using a discount rate that is consistent with the anticipated levels of interest rates in the future market, will define the incremental value associated with leasing available to be passed through to the Lessee (assuming lease and debt yields are equivalent). These findings, which are solely related to the increased discount rate associated with a market characterized by higher interest rates, are found in Table 2, below.

[IMGCAP(5)]

The findings presented in Table 2 reflect that the value of tax benefits associated with leasing is dependent on the level of interest rates found in the market. At higher interest rates, the tax benefits associated with leasing have a greater value to a Lessor, and provide Lessors the ability to more competitively price their offering against debt financings targeting the same pretax returns. While the actual results are highly dependent on the specifics of a certain transaction ' including timing, transaction structure, and interest rates and yields associated with the risks defined by the customer and transaction ' the resulting position is that as interest rates rise (as well as targeted returns rise associated with transaction risks), Lessors have an ability to improve their comparative pricing against debt financings while maintaining an equivalent return.

Increased Exposure to the Alternative Minimum Tax

In 2000 13,135 corporations reported an Alternative Minimum Tax (AMT) liability totaling $3.9 billion ' representing a 27% increase from 1999. However, due to the lack of economic growth for 2001, the regular and alternative minimum tax bases declined resulting in 7101 corporations reporting a total AMT liability of $1.8 billion in 2001.

The Tax Reform Act of 1986 instituted the AMT as a tool to ensure that taxpayers paid a minimum amount of income tax in spite of legitimate use of exclusions, deductions and credits. For most of its existence the AMT has had a minimum effect on taxpayers, with less than 14,000 of the 5 million corporate tax returns filed in 2000 being subject to the AMT (2.8 million corporate tax returns reflected positive pretax earnings). However, for those corporations that are subject to the AMT, the increase in taxes over their regular tax liability can be serious; in fact, while the number of corporate taxpayers reporting a AMT liability declined by 13.4% in 2000, the amount of AMT liability reported by those corporations increased by 27%.

Corporations subject to the AMT have a right to claim a Minimum Tax Credit equal to the aggregate amount of all AMT paid for tax years beginning after 1986, less all Minimum Tax Credits already taken. Subject to certain rules, the Minimum Tax Credit can be used in subsequent years to reduce an entity's regular tax liability, but not below that of its tentative minimum tax. As such, the Minimum Tax Credit can only be claimed in years that the corporation has no AMT liability.

A review of corporate tax data available through the GAO and IRS suggests that between the years of 1987 and 2002 AMT liabilities exceeded the amount of Minimum Tax Credits claimed by nearly $20 billion (or 46.6%). For those taxpayers who can fully utilize their Minimum Tax Credits, the cost of the tax is equal to the time value of money associated with the early establishment of a tax liability through the AMT, a position supported by the work of Professor Andrew B. Lyon (University of Maryland) who has documented that firms undertaking investment in equipment while temporarily subject to the AMT generally face a higher cost of capital than firms that are only subject to the regular tax liability. For entities who must wait a long time to fully utilize their Minimum Tax Credits, or that are never able to utilize them, the resulting increase in their cost of capital can be substantial.

Entities that operate in industries characterized as being equipment intensive and as having low profit margins are considered to have a high propensity to become subject to the Alternative Minimum Tax (AMT) provisions of the U.S. Income Tax Code. While the depreciation adjustment (the difference between the amount of depreciation expense claimed by a taxpayer using the standard MACRS deduction, and the amount of depreciation expense derived using the 150% declining balance method) is just one of a set of adjustments and preferences that can subject a taxpayer to the AMT, it is through the leasing of assets (versus owning and depreciating assets) that an entity can minimize or eliminate the depreciation adjustment used to determine its Alternative Minimum Taxable Income, and ultimately its AMT.

With an improving economic climate, one would expect that tax liabilities ' under both the Regular and Alternative Minimum tax systems ' would increase. However, factors beyond the economy are at play here, including:

• Expiration of Bonus Depreciation rules will subject more equipment to the depreciation adjustment under the rules used to calculate AMT liability; and
• Projections concerning the AMT impact on individuals will have a similar, and possibly a greater impact on pass-through entities, including S corporations.

The bonus depreciation rules that have been in effect since the passage of the Economic Security and Recovery Act of 2001 (and subsequently, the Job Creation and Worker Assistance Act of 2002) have provided that equipment purchased and depreciated using the bonus depreciation rules was not subject to the depreciation adjustment rules under the AMT system. Effective Jan. 1, 2005 the bonus depreciation rules will expire for most types of equipment, and all equipment having a MACRS life of 3 through 10 years and depreciated using the Modified Accelerated Cost Recovery System will cause an adjustment to be made when determining AMT liability; specifically the difference in depreciation allowances using a 200% declining balance method (the MACRS method) and the AMT prescribed 150% declining balance method, will result in an adjustment for determining AMTI, and any resulting AMT liability.

In her 2003 report to Congress, Nina Olsen, the IRS's National Taxpayer Advocate, characterized the AMT as “the most serious problem faced by taxpayers.” While less than 1% of individual taxpayers have paid any AMT through 1999, in 2000 1 million taxpayers were subject to the tax, and 30 million taxpayers are expected to be subject to the tax in 2010. AMT receipts in 2010 are projected to total $90 billion, impacting 20% of all taxpayers, and 40% of all married couples. Further analysis indicates that two-thirds of taxpayers with an AGI between $50,000 and $100,000 will have an AMT liability; 90% of taxpayers with an AGI between $100,000 and $500,000 will have an AMT liability; and 30% of taxpayers with an AGI over $500,000 will be subject to the AMT in 2010. Taxpayers on the upper end of the income spectrum tend not have AMT liability because a large portion of their income is taxed at Regular tax rates that exceed AMT rates.

The projected increase in AMT exposure is, for the most part, attributable to inflation. The Regular tax system is indexed for inflation, but the AMT is not.

Certain business income is taxed at the individual level, including Schedule C and partnership income, as well as corporate profits of flow-through entities ' S Corporations and Regulated Investment Companies. For 2000 and 2001 flow-though corporate entities reported profits of $373 billion and $299 billion, respectively. It can reasonably be assumed that much of these profits will accrue to those taxpayers that will begin to see their AMT exposure rise through the end of the current decade.

In addition to subjecting a taxpayer to additional tax ' the AMT ' entities that find themselves in an AMT position need to adjust their assumptions when evaluating the lease v. purchase decision. When conducting a lease versus purchase analysis, expenses such as interest and depreciation have an after-tax cost equal to 1 minus the tax rate. For a C corporation in a 35% tax bracket, $500,000 of depreciation expense has an after-tax cost of $325,000 [$500,000 x (1 - 0.35) = $325,000]. However, the same C-Corporation when subject to AMT liability is now paying taxes at the corporate AMT rate of 20%, causing the true after-tax cost to increase to $400,000 [$500,000 x (1 - 0.20) = $400,000]. As such, any lease v. purchase analysis must use the AMT rate as the appropriate tax rates ' resulting in an increased cost of ownership. Note: For a flow-through entity, the analysis would use the individual AMT rates of 26% on the first $175,000 of AMT Taxable Income, and 28% on any AMT taxable income in excess of $175,000.

Best Use of Tax Benefits Associated with Equipment Ownership

As discussed in the section addressing interest rates and their impact on the relative competitiveness of leasing v. debt financing, leasing's economic value is, in part, associated with the Lessor's ability to defer taxes it may owe and then pay those taxes with discounted dollars. This is accomplished by using the depreciation associated with an asset to shelter revenue streams associated with that lease, as well as other revenue streams. The tax shelter associated with an expense is equal to the expense, times the taxpayer's marginal tax rate, which at the top corporate bracket is 35%. Therefore, an asset costing $1 million has the ability to shelter income equal to $350,000 [$1,000,000 x 0.35 = $350,000]. Most all Lessors assume a 35% federal tax rate, and some assume an additional state tax burden. If, however, the Lessor were only to have a 25% marginal tax rate, the tax shelter associated with the depreciation is reduced. Assuming the same $1 million asset, the asset has the ability to shelter income equal to $250,000 [$1,000,000 x 0.25 = $250,000].

The same is true for the user of the equipment considering a purchase. A corporation having income sufficient to place it in a 35% corporate tax bracket will have a higher utility for the depreciation associated with ownership and could use the depreciation to shelter income totaling $350,000. If, however, the equipment user were in a 25% tax bracket, the shelter would be reduced to $250,000. In either situation the corporation may elect lease financing for one reason or another, but in the case of the 25% taxpayer, management may find it advantageous to lease the asset from a Lessor that can more fully use the tax benefits, who passes his benefit through to the Lessee in the form of reduced rents.

Continued Consolidation of Providers of Capital (ie, the Commercial Banks)

Within the past year we have observed Bank of America purchase Fleet Boston; JP Morgan Chase purchase BankOne; and Wachovia purchase SouthTrust. These, and other corporate actions, represent a continuation of consolidation activities that occurred in the financial services industry over the past decade, and they can be expected to continue.

Every institution has lending limits. Consolidations seldom occur where the amount of credit available to a particular name equals to the sum of the exposures each institution had prior to the acquisition. Rather, exposure levels may have to be reduced, or future business may have to be reduced or syndicated. Equipment leasing companies have always served as an alternative source of capital, and will continue to do so.

Summary

In this article we have discussed leasing and the extent that it has been positioned as a financing tool for American business. We have briefly reviewed some of the historic reasons Lessees lease. We have also discussed a number of issues that are specific to the current environment that will most likely serve to further motivate additional leasing activity. However, leasing is not specifically dependent on an increasing interest rate environment, nor a continuation of consolidation among alternative providers of capital, nor an expansion of taxpayers subject to the AMT to maintain it market positioning. Lessees lease for a multitude of reasons ' both historic and evolving. It is true that the accounting framework may impact how certain leases are structured, and it is equally true that with the expiration of bonus depreciation lease rates will be increasing (but so will the after-tax cost of all forms of equipment ownership). It will be the understanding of a Lessee's needs, coupled with a willingness to solve financial and operational problems, that will allow Lessors to continue to provide Lessees with products that will serve as viable financing tools for both old and new reasons.