What To Know Before Leasing a Car for Business

A woman taking a test drive with a salesman.
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Many business owners lease cars for business use, as the attractive monthly costs and the ability to change cars frequently to keep up with new technology and safety features are appealing.

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 the tax implications of doing so.

Key Takeaways

  • You have two options for leasing a company car: An open lease ,like renting, or a closed lease, similar to buying the car.
  • You can deduct costs of the lease and driving costs during the lease period, but only for the percentage of use for business purposes.
  • Lease terms include mileage costs and normal wear and tear; excess costs must be paid at the end of the lease term.
  • You may be able to depreciate the vehicle if the lease agreement includes the option to buy the car at the end of the lease period.

Lease Terms You Need to Know

Open-End vs. Closed-End Lease

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-end lease and a closed-end lease. 

In an open-end lease contract, the lessee pays the difference between the residual value (estimated resale value) and the actual resale value at the end of the lease.

In contrast, at the end of a closed-end lease, the lessee pays only extra mileage and extraordinary damages.

Residual Value

Residual value describes the value of the car at the end of the lease, depending on the amount and rate of depreciation on the car. The longer the term of your lease, the lower the residual value will be because the vehicle will be older when you return it.

Term Length

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

It's always a good idea to match the term of a lease to your business needs. If a company car is driven a lot and traded in regularly, your best option might be a shorter term lease.

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.

Who Can Deduct Business Driving Expenses?

A small business can deduct expenses for driving a car that is owned or leased, but only for business expenses. Your business can deduct lease costs and driving costs. You may also be able to depreciate the lease costs, depending on type of lease.

No matter whether you lease or buy a car for business use, you can only deduct business expenses, not personal expenses. Commuting back and forth to work is a personal expense.

Employees can no longer deduct costs for driving company cars if they aren't reimbursed by their employer, because the IRS has suspended miscellaneous itemized deductions through Jan. 1, 2026.

Deducting Business Lease Costs

You can deduct ordinary and necessary lease costs for a car you use in your business.

To deduct lease costs and driving expenses, you must be able to prove your business mileage and that you drove the car more than 50% of the time for business use.

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

  • 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
  • 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 bonus (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 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, not personal purposes (and you must be able to prove the amount of business driving each year).
  • Then, to deduct the lease payment, you must use the actual expenses method (not the standard mileage 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 for deduction purposes. 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.

Frequently Asked Questions (FAQs)

Is it better to buy or lease a car for your business?

The specific circumstances of your business will determine whether it's better to buy or lease a company car, but here are some points to consider:

  • Monthly lease payments are usually less than monthly loan payments, because lease payments only include depreciation, interest, taxes, and fees.
  • You will probably have to pay excess wear and tear costs for a leased car, but the condition of the vehicle is considered as part of the fair market value of a purchased car.
  • You can deduct business mileage for both leased or bought vehicles, but there may be some restrictions if you use actual mileage for leased vehicles.
  • The main difference in leasing vs. buying a company car comes in your ability to depreciate the cost of the car. You can always depreciate the cost of a purchased vehicle, but some types of leases don't allow depreciation.

How does a company car lease work?

The lease agreement specifies the monthly payments and other charges, the term of the lease, and the number of the miles included in the lease price. You may turn in the lease at the end of the term, but you may buy the vehicle, if the option is included in the lease agreement.

Ending the lease early may result in a prepayment penalty, with the amount of the penalty depending on how early the lease is ended by the lessee.

Your company is responsible for mileage in excess of the agreed-upon mileage. In addition, if there is "excess wear and tear," as defined by the lease agreement, you may be responsible for these charges.

Is leasing a car for business tax-deductible?

You may deduct all ordinary and reasonable costs for driving expenses and other lease costs as business expenses, including lease costs, insurance, and maintenance. If the vehicle is used for both business and personal purposes, you must separate out the personal portion and only deduct the mileage portion. For example, if you drive the car 60% of the time for business purposes, you can only deduct 60% of costs.

Deductible costs include the monthly payments and costs for driving expenses. You can use either the IRS standard mileage or actual costs for deducting driving costs.

In addition to normal yearly costs, you may be able to deduct the cost of depreciation during the term of your lease for your leased company car if you use the car more than 50% of the time for business purposes.

To be able to deduct depreciation, the lease must be a conditional sales contract, as defined by the IRS. In this type of lease agreement, the lessee has the right to buy the car under "advantageous" terms.