What to Know Before Leasing a Company Car for Business

A woman taking a test drive with a salesman.
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Many business owners are leasing cars for business use. The attractive monthly costs and the ability to change cars frequently to keep up with new technology and safety features are appealing. But is a leased car right for your business? Here are some factors to consider in a decision to lease or buy a company car, how to lease that car (including options), and tax implications of leasing a company car.

Lease Price Factors

  • The Manufacturer's Suggested Retail Price (MSRP)
  • The final negotiated price of the vehicle
  •  The down payment, if any
  • The usage (sales)tax rate in your area
  • The length of the lease
  • The new car lending rate (also available on Bankrate.com)
  • The car value at the end of the term (the residual value).

Lease Terms You Need to Know

Open Lease vs. Closed

When you sit down to negotiate a lease for a company car with a car dealership, you will probably be offered two options: an open lease and a closed lease. An open lease contract is used primarily for commercial (business) vehicle leases. In this type of lease, the lessee pays the difference between the residual value (estimated resale value) and the actual resale value at the end of the lease. If the vehicle is driven more than estimated, the actual resale can be low, resulting in increased costs for the lessee. In contrast, at the end of a closed lease, the lessee pays only extra mileage and extraordinary damages.

Residual Value

It is a term used in car leases. It describes the value of the car at the end of the lease. The term "residual value" is also used to describe the amount a business expects to sell an asset for at the end of its useful life.

The residual value is a function of the amount and rate of depreciation on the car or other business assets. The longer the term of your lease, the lower the residual value will be (because the vehicle will be older when you return it). Thus, you will pay more in total depreciation with a longer-term lease.

Consider Lease Term Length

Shorter-term leases are more costly than long-term leases because the residual value goes down faster in the first 24 months.Try to match the length of the lease to your needs and preferences. Negotiating a longer lease will generally lead to a lower monthly payment, but deciding to end a longer lease early could be costly.

Estimated Annual Mileage

Before you go into a lease, you will need an estimated annual mileage for your use of the car. A typical lease might have a 12,000-mile annual limit, but if you think you will be running at more than 12,000 miles a year, it's worth it to pay extra for the additional mileage. Otherwise, you will have to pay for the additional mileage used at the end of the lease.

Taxes for Lease Costs - Deducting or Depreciating

As always is the case in business financial matters, you'll need to think about how taxes will work for the lease. You can deduct "ordinary and necessary" lease costs for a car you use in your business.

No matter whether you lease or buy a car for business use, you can only deduct business expenses for that vehicle, not personal expenses. You must calculate the actual driving mileage for the year so you can prove that you drove the car more than 50% of the time.

For tax purposes, there are two types of leases, depending on the type of contract:

  • The lease as rent expense. If the agreement is a true lease, you can deduct the payments as rent.
  • If the lease is really a conditional sales contract, you must depreciate the cost over time.

A conditional sales contract exists when at least part of the payments are applied toward the purchase or entitle the taxpayer to buy property under advantageous terms. The IRS has set some conditions that are used to determine if a conditional sales contract exists:

  • Whether the agreement sets part of each payment to equity (ownership),
  • If you get the title to the car at any point,
  • If the amount to pay to use the property is an inordinately large part of the amount you would pay to get title to it,
  • If you pay much more than current fair rental value,
  • If you have the option to buy at a small amount, or
  • If the agreement sets some part of the payments as interest or if it's easy to recognize as interest.

Depreciating Lease Costs

You must depreciate the cost of the car lease if it has what the IRS calls a conditional sales contract, as explained above. If you use the vehicle 50% or less of the time in a year, you can't take a Section 179 deduction or special depreciation allowance. You must also figure depreciation using the straight line method over five years. 

Depreciating a vehicle is a complicated process. This calculation is a job for your tax professional.

Deducting Lease Costs

If you choose to use actual expenses, you can deduct the part of each lease payment that is for the use of the vehicle in your business. You can’t deduct any part of a lease payment that is for the personal use of the vehicle, such as commuting.

Deducting Driving Costs

You have two options for deducting driving costs for your leased company car. The options depend on whether you use actual costs or the standard deduction for the year. You may deduct business driving costs for a leased car under certain circumstances and within limits. 

  • First, you must use the car 50% or more of the miles for business purposes (and you must be able to prove the amount of business driving each year). You can deduct only the business driving portion of the costs of driving the leased car.
  • Then, to deduct the lease payment, you must use the actual cost method (not the standard deduction) to calculate driving deductions.
  • Finally, a higher value leased vehicle may be subject to what the IRS calls an "inclusion amount," which is a reduction in the deduction for the lease cost.

Don't forget about sales taxes. Check with your state to see if they charge sales tax on vehicles leased for a year or more. The lower the cost of the vehicle, the lower the sales tax rate.