Monthly rental payments made by a lessee obviously constitute taxable rental income. But rental income can encompass other types of payments, too. If lessors aren’t careful, they could end up on the hook for more tax liability than expected, as well as significant penalties. One development company recently learned this lesson the hard way in the case of Stough v. Commissioner.
Stough Development Corporation (SDC) is a real estate development company that’s primarily in the business of acquiring and developing real estate for use as plasma collection centers. The company operates as a pass-through S corporation. Talecris Holdings operates plasma collection centers throughout the country. In 2006, SDC and Talecris entered into a development agreement under which SDC would acquire property and construct a collection center to Talecris’ specifications.
In 2008, Talecris executed a 10-year lease with a limited liability company wholly owned by SDC’s owner. The lease required the lessee to pay monthly rent determined by a mathematical formula based on “project costs” that SDC incurred in acquiring and developing the plasma collection center.
Under the lease, Talecris could elect to pay the lessor a lump sum for any portion of the project costs, which would reduce those costs and, in turn, reduce the rent the lessee owed under the lease. Talecris made a $1 million lump-sum payment in April 2008.
On their 2008 tax return, SDC’s owner and his wife reported $1.15 million in rents received in connection with the plasma center rental — the sum of monthly rent and the lump-sum payment. They claimed a deduction for a $1 million “contribution to construct” expense.
In 2010, the IRS began an audit of the couple’s 2008 tax return. The agency ultimately issued them a notice of deficiency for the tax year, disallowing the $1 million deduction. The taxpayers appealed.
Although the taxpayers initially reported the lump-sum payment as rental income, they argued on appeal that the reporting was in error and the payment wasn’t rental income. Specifically, they asserted that the payment wasn’t intended as rent by the parties but rather was meant to reimburse the lessors for leasehold improvements.
The Internal Revenue Code (IRC) defines “gross income” as all income from whatever source derived, including rental payments received or accrued during the taxable year. As the Tax Court explained, when a lessee pays an expense or obligation incurred by the lessor in bringing the leased property into existence, the lessor receives a direct economic benefit to the extent the lessor is relieved of his or her financial obligation. In such cases, the court said, it need not inquire into the lessor and lessee’s intent unless the payments were unrelated to the lease.
In this case, it was indisputable that the lump-sum payment was:
- Made pursuant to the lease terms,
- Optional for the lessee,
- Meant to reimburse the lessor for project costs in bringing the property into existence, and
- Reduced the lessee’s future rents.
The payment, therefore, represented payment of the lessor’s expenses, the court said and constitutes rent without the need to inquire into the parties’ intent.
The Tax Court conceded that situations could arise where an improvement made by a lessee isn’t intended to compensate a lessor. Indeed, an improvement could be worthless or even detrimental to the lessor.
In those circumstances, the parties’ intent should determine whether it’s rent. Talecris made no leasehold improvements, though — rather, it exercised its option to make a payment to reduce the amount of project costs for purposes of calculating annual rent.
Proceed with caution
The proper reporting of rental income to the IRS isn’t always as straightforward as it may seem, as the IRS’s definition of rental income can extend further than lessors might expect. If a lessor’s misunderstanding of what constitutes rental income is discovered during an audit, it could prove costly.
For more information contact your MarksNelson professional.
About the author
Julie Raymond works with clients in the real estate industry, helping them with their tax planning and compliance to minimize their tax liability. To be most effective, Julie works with clients year-round to help them understand the tax implications before they make crucial decisions.