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.
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.
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. 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 pointIf the amount to pay to use the property is an inordinately large part of the amount you would pay to get title to itIf you pay much more than current fair rental valueIf you have the option to buy at a small amountIf 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.
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.
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.
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. 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.
