In Uncategorized on 06/02/2015 at 17:55

We used to play with front-loaded and back-loaded rent to get the tax result we wanted, skirting the Section 467 ratable-allocation-of-rent rules.

But Judge Ruwe is less than kind in Michael H. Stough and Barbara M. Stough, 144 T. C. 16, filed 6/2/15.

Mike and Barb built a commercial building and leased it for 10 years. Fixed minimum rent was based on cost of land acquisition and construction costs (presumably hard and soft). Tenant had a one-time option to pay down $1 million lump-sum, with a concomitant reduction in rent going forward. Mike and Barb claimed the $1 million was a “contribution to construct” expense, and deducted it on Schedule E.

Mike and Barb had a disregarded LLC holding the land and building, of course.

IRS blew off the deduction, and allowed Barb and Mike additional depreciation. But the $1 million was income in the year received, said IRS, not spread over the lease term. Mike and Barb claim the tenant was paying them back for leasehold improvements, but Reg. 1.61-8(c) eliminates the need to delve into owner’s and tenant’s subjective intents. What lessee paying lessor is rent, absent some real evidence otherwise.

“There may be situations where an improvement made by a lessee is not intended to compensate a lessor. Indeed, an improvement by a lessee might be worthless or even provide a detriment to the lessor. For example, the useful life of such an ‘improvement’ by the lessee may not extend beyond the term of the lease, in which case it has no value to the lessor and, in fact, may impose a financial detriment if the lessor is responsible for its removal upon termination of the lease. Here the lessee made no leasehold improvements. Rather, the lessee exercised its option to pay $1 million to petitioners in order to reduce the amount of ‘project costs’ for purposes of calculating annual rent.” 144 T. C. 16, at pp.13-14.

OK, it’s rent. Hardly surprising, but how is it to be taxed, ratably over the life of the lease or as a lump-sum payment in year received?

This is a case of first impression, so best pay attention.

“Congress enacted section 467 to prevent lessors and lessees from mismatching the reporting of rental income and expenses. Section 467 provides accrual methods for allocating rents pursuant to a ‘section 467 rental agreement’. In order to qualify as a section 467 rental agreement, an agreement must have: (1) increasing/decreasing rents or deferred/prepaid rents and (2) aggregate rental payments exceeding $250,000. Both parties agree that the lease in this case qualifies as a section 467 rental agreement.” 144 T. C. 16, at pp. 15-16. (Citations and footnote omitted).

The rule in a Section 467 rental agreement is to allocate rent per the agreement. But is there a specific allocation here?

No, says Judge Ruwe. All the lease says is that the lessee can make the $1 million lump-sum payment, but doesn’t allocate the payment to a specific portion of the lease term.

And the constant rental accrual method in Section 467(b)(2) only applies to long-term leases and sale-leaseback deals, and where IRS determines there is an abusive transaction, none of which apply here. And the $1 million is not “prepaid rent” because the formula goes on, and the rent at year end for the year in which the $1 million was paid does not exceed the rent payable for the next year.

I find Judge Ruwe’s arithmetic puzzling. Let’s see what Sixth Circuit does with this.

Anyway, Mike and Barb claimed they relied on their trusty CPA, but Mike only skimmed the return and didn’t check out the Schedule E legerdemain.

“Claiming reliance on [trusty CPA] and choosing to not adequately review the contents of a tax return is not reasonable reliance in good faith, and we will not permit petitioners to avoid an accuracy-related penalty for substantially understating their income tax liability. Accordingly, we hold that petitioners are liable for the accuracy-related penalty under section 6662(a).” 144 T.C. 16, at p. 29.

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