Is it Rent? That Depends on the Lease
A recent Tax Court decision sheds light on the importance of lease terms to determine what is rent and how Sec. 467 may apply to advance rents.
by Annette Nellen, Esq., CPA, CGMA
The Tax Court’s recent decision in Stough, 144 T.C. No. 16 (2015), serves as an important reminder of the relevance of lease terms and Form 1099-MISC, Miscellaneous Income, as well as a good review of the rental income rules under Secs. 61 and 467. In addition, according to the court, discussion of Sec. 467 was one of “first impression” for the court. The court also upheld a substantial understatement of tax penalty—another reason this case is worth a close look.
Stough is the sole shareholder of Stough Development Corp. (SDC), an S corporation that acquires and develops real estate primarily for use as plasma collection centers. The transaction in this case started in December 2006 with a development and guaranty agreement between SDC and Talecris Biotherapeutics Holdings Corp., an operator of plasma collection centers, which also included a proposed lease under which Talecris would rent the property from SDC for at least 10 years. SDC was to acquire a location and construct the center to Talecris’s specifications.
After suitable property was located in September 2007, SDC borrowed funds to obtain the property, with Stough personally liable on the debt. He transferred the property to his wholly owned limited liability company (LLC), a disregarded entity. Talecris moved into the building in February 2008. Although the original lease proposal was not yet executed, Talecris paid rent starting March 1, 2008.
A final lease was executed between the LLC and Talecris in June 2008. Monthly rent was determined by a formula: ([Project costs × 90%] × 125%) ÷ 12. Project costs were defined as the total of acquisition costs, hard and soft construction costs, and financing costs.
The lease terms allowed Talecris to notify the LLC, on or before the lease term began, that it would make a lump-sum payment of any portion of the project costs, which Talecris did in April 2008. It made a payment of $1 million for project costs, which lowered the monthly rent.
Talecris issued a Form 1099-MISC to the LLC for 2008 for $1,151,493, representing the lump-sum payment and $151,493 of monthly rent for the year. Stough’s joint return for 2008, prepared by a CPA, included a Schedule E, Supplemental Income and Loss, for the Talecris rental property reporting rental income in the amount on the Form 1099-MISC minus a deduction of $1 million as a “contribution to construct” expense.
An IRS examination of Stough’s return began in April 2010, and that November SDC requested that Talecris issue an amended Form 1099-MISC, treating the $1 million lump-sum payment as a “buy-down reimbursement,” which Talecris did. The IRS disallowed the $1 million Schedule E deduction and increased basis in the property, which resulted in approximately $88,000 of additional depreciation for the year.
In the Tax Court, Judge Robert Paul Ruwe addressed three issues: (1) rental income, (2) Sec. 467, and (3) the Sec. 6662 penalty.
Tax Court calls it all rental income
The court examined the lease terms and looked at the financial benefits Stough received. It also applied Sec. 61(a)(5) and Regs. Sec. 1.61-8(c). Sec. 61(a)(5) states that rents are an example of gross income. Regs. Sec. 1.61-8(c) provides that generally any expenses a lessee pays are treated as rental income to the lessor. Proper classification depends on the intent of the parties, as discerned by the lease terms or “surrounding circumstances.”
According to the court, it was clear that the $1 million payment was related to the lease. Under Regs. Sec. 1.61-8(c), this payment toward the lessor’s expenses was a financial benefit and clearly rent, and there was no need to delve into the parties’ “subjective intent.” The court decided not to examine subjective intent for the following reasons:
- The lump-sum payment option was included in the portion of the lease labeled “rent.”
- The lessee’s representative testified that the purpose of the lump-sum payment was to give it flexibility in its monthly rent payments.
- Both parties treated the lump-sum payment as rental income before the IRS examination began
Sec. 467 doesn’t change the result
Sec. 467 was added to the Code to address certain tax avoidance schemes involving rental arrangements that resulted in rent deductions before the lessor reported the rental income. It is a fairly complex provision. Stough suggested that this rule required the lump-sum payment to be reported ratably over the lease term, but the court disagreed.
Key to application of Sec. 467 is the existence of a “section 467 rental agreement,” which must have:
- Increasing or decreasing rents or prepaid or deferred rents, and
- Total rental payments in excess of $250,000.
The court, Stough, and the IRS agreed the lease was a “section 467 rental agreement” because rents increased in the second half of the lease term. But that is not enough for Stough to be able to recognize the rental income over a number of years as Stough argued.
Sec. 467(b) covers accrual of rental payments. Generally, under Sec. 467(b)(1), the allocation follows the lease terms provided no rent is payable after the lease term. An exception at Sec. 467(b)(2) calls for a “[c]onstant rental accrual in case of certain tax avoidance transactions.” Applying Regs. Sec. 1.467-1(c)(2), the court found that the lease did not “specifically allocate” fixed rent to rental periods. In such a situation, the regulations provide that “the amount of fixed rent allocated to a rental period is the amount of fixed rent payable during that rental period.” Thus, the rent payable for 2008 was allocated to Stough’s 2008 rental period under Regs. Sec. 1.467-1(c)(2)(ii)(B).
Stough could not use the “constant rental accrual” method because, under Regs. Sec. 1.467-3(a), it applies only if the IRS determines that the rental agreement is disqualified. For a rental agreement to be disqualified, a principal purpose for changing rent payments must be tax avoidance, or it must be a “disqualified leaseback or long-term agreement.” The lease at issue here did not meet the definition for disqualified leasebacks or long-term agreements (Regs. Sec. 1.467-3(b)).
Finally, the court held that the “proportional rental accrual” of Regs. Sec. 1.467-2 did not apply because the agreement had no prepaid rent as defined at Regs. Sec. 1.467-1(c)(3)(ii). So, the $1 million payment was all rental income for 2008.
The court upheld the 20% substantial-understatement penalty under Secs. 6662(a) and (b)(2), rejecting Stough’s argument that the penalty should be waived because he reasonably relied on his preparer. As the court noted, this argument works only if Stough “exercised ordinary business care and prudence as to the disputed item.” A three-pronged test is used to determine if this standard is met:
- The adviser is competent with sufficient expertise;
- The taxpayer provided appropriate information to the adviser; and
- The taxpayer “actually relied in good faith on the adviser’s judgment.”
The court found that the third prong was not met because Stough had not devoted sufficient time to review his Schedule E. He should have seen the $1 million deduction and known it was not permissible. “[E]ven had it been related to the acquisition and construction of the plasma collection center, [it] would not have been deductible in total in 2008,” the court said.
A different legal structure for the construction and lease that tied to the economics of the costs and benefits to the parties might have allowed for the result on the original return (the lump-sum payment’s reducing property basis). Given the court’s interpretation of the lease terms, use of a “corrected” Form 1099-MISC before filing would not have changed the result. Likely, more time devoted upfront to the desires of both parties and ensuring that the contract terms corresponded to those desires was needed.
The court’s reminder of the necessity for taxpayers to carefully review their returns is arguably also a subtle reminder for preparers to make sure that time is available, and that preparers remind clients of their responsibility for the contents of their returns.
This case is a reminder of the complexities of Sec. 467. Its review as part of any tax reform effort would be productive to ensure it still makes sense today and can be readily and fairly applied by both taxpayers and the IRS. In addition, the desire and need for taxpayers to clarify or correct Forms 1099 and other reporting forms is not uncommon. Perhaps the IRS should develop a new form to allow taxpayers to reconcile and explain problems. This would go a long way to improve compliance and also aid in audit selection.