Why Speak to the Tax Adviser?

I don’t know about you, but most tax advisers hate surprises. I certainly do. Many taxpayers, on the other hand, seem to invite them. While I doubt that they look forward to being surprised, they often go into transactions without first looking into what the income tax consequences will be.

Truth be told, some transactions seem straightforward or innocuous enough, and, so, the taxpayer will say to him- or herself: “Self, I can handle this on my own. Why pay that tax adviser to worry me?”

That may be what one taxpayer thought in a recent decision where the Tax Court  considered whether a $1 million lump-sum payment made by a tenant was rental income to its landlord and, if so, whether the landlord could allocate the payment proportionately over the life of the lease.

 The Project

Taxpayer was the sole shareholder of an S corporation (Corp) that operated as a real estate development company primarily in the business of acquiring and developing real estate for use as medical centers. Tenant operated medical collection centers throughout the country.

In 2006, Corp and Tenant entered into a development agreement wherein Corp agreed to acquire real property in a location acceptable to Tenant and to construct a center pursuant to Tenant’s specifications.

In 2007, pursuant to the terms of the development agreement, Corp acquired title to a parcel of real property in its wholly-owned LLC (a disregarded entity for purposes of the federal income tax).  In order to fund the acquisition of the property and to facilitate the subsequent construction of the center, Corp took out a commercial loan with Bank for which Taxpayer was personally liable. Tenant was not liable on or obligated to make payments under the loan.

The Lease

In 2008, LLC and Tenant executed a lease whereby Tenant agreed to lease the center from LLC for 10 years. The lease required Tenant to pay a monthly base rent to LLC that was determined by a formula based on the “project costs” that Corp incurred in acquiring and developing the center. The lease allowed Tenant, on or before the commencement date, to elect to pay or reimburse LLC in a lump sum for any portion of the project costs. If Tenant made such an election, then, for purposes of determining the base rent, the project costs would be reduced by the amount of such payment. Because rent was a function of project costs, a lump-sum payment would reduce project costs, and consequently, reduce the amount of rent that Tenant owed under the lease. It was within the sole discretion of Tenant to make an election.

Tenant made a $1 million lump-sum payment to LLC pursuant to the election set forth in the lease. Taxpayer applied the $1 million lump-sum payment to the outstanding balance of the Bank loan.

The Tax Mess

Tenant issued to LLC a Form 1099-MISC reporting the aggregate monthly rent for the center for 2008 along with the $1 million lump-sum payment pursuant to the election provided by the lease. Taxpayer filed a Form 1040, U.S. Individual Income Tax Return, for 2008. On one of the Schedules E attached to the return, Taxpayer reported rents received that included the $1 million. Among the deductions that Taxpayer claimed on this Schedule E was a $1 million “contribution to construct” expense. In 2010, the IRS examined Taxpayer’s 2008 tax return. Corp requested that Tenant  amend the original Form 1099-MISC issued to LLC to treat the $1 million lump-sum payment as a “buy-down reimbursement” of construction cost. Tenant complied with the request. In 2011, The IRS issued a notice of deficiency for 2008, disallowing the claimed $1 million Schedule E deduction, and increasing Taxpayer’s basis in the center and allowing additional depreciation (presumably recoverable over thirty-nine years). Taxpayer petitioned the Tax Court.

Although Taxpayer initially reported this amount as rental income on one of his Schedules E, he now argued that this reporting was in error and that the $1 million lump-sum payment did not constitute rental income for 2008. Specifically, Taxpayer argued that the $1 million payment was not intended as rent by the parties to the lease but rather was meant to reimburse Taxpayer for leasehold improvements to the center.

The IRS argued that the $1 million payment received by the Taxpayer was rental income and was properly reported as such on Taxpayer’s 2008 return.

The Court

As a general rule, if a lessee pays any of the expenses of his lessor, such payments are additional rental income of the lessor. Similarly, if a lessee places improvements on real estate which constitute, in whole or in part, a substitute for rent, such improvements constitute rental income to the lessor. Whether or not improvements made by a lessee result in rental income to the lessor in a particular case depends upon the intention of the parties, which may be indicated either by the terms of the lease or by the surrounding circumstances. However, when a lessee pays an expense or obligation incurred by the lessor in bringing the leased property into existence, there is a direct economic benefit to the lessor to the extent that the lessor is relieved of his or her financial obligations. Under these circumstances there is no ambiguity regarding the financial benefit that the lessor receives. That being the case, there need be no inquiry into the intent of the lessor and lessee unless the lessee’s payments were unrelated to the lease.

In the instant case there was no question that the $1 million lump-sum payment was:

  • Made pursuant to the terms of the lease;
  • Optional at the election of the lessee;
  • To “reimburse” the lessor for “project  costs” (including financing, hard and soft construction costs) incurred and paid by the lessor in bringing the property into existence; and
  • The cause of a reduction of the lessee’s future rents otherwise due.

Given these facts, the $1 million lump-sum payment constituted rent without the need to inquire into the subjective intent of the parties.

The Tax Adviser?

So much for simple and straightforward.

So, what might a tax adviser have said to the taxpayer in these circumstances? In the first instance, the advisor would have informed the taxpayer that the receipt of the lump sum payment was taxable. In effect, the lease provided that rents would be reduced in consideration of the lessee’s payment for the capital improvements constructed by the lessor.

The advisor might then have suggested some alternative options.

What if the lessee had agreed to make some of the improvements and there had not been an explicit reduction in the rent payable? As discussed above, the parties’ intent would then have to be determined.  Each of the parties will own certain improvements. Provided the lessee has no obligation to pay for the lessor’s improvements, and the lease does not treat the lessee’s improvement obligation as a rent substitute, the lessor should not realize additional rental income.

What if the lessor had offered the lessee a rent holiday? Provided it was not tied to the improvements to be made by the lessee, the lessor may escape the recognition of income.

What if the lessee’s payment was structured as “prepaid rent” within the meaning of IRC Sec. 467? For example, A and B enter into a rental agreement that provides for a 10-year lease beginning on January 1, 2015, and ending on December 31, 2024. The rental agreement provides for accruals of rent of $10,000 during each month of the lease term; $120,000 is allocated to each calendar year. The rental agreement provides for a $1.2 million payment on December 31, 2015.

The rental agreement provides prepaid rent because the cumulative amount of rent payable as of the close of a calendar year exceeds the cumulative amount of rent allocated as of the close of the succeeding calendar year. For example, the cumulative amount of rent payable as of the close of 2015 ($1.2 million is payable on December 31, 2015) exceeds the cumulative amount of rent allocated as of the close of 2016, the succeeding calendar year ($240,000). Accordingly, the rental agreement is a so-called “section 467 rental agreement.” As such, the prepaid rent may be accrued proportionally over the term of the lease, provided certain other requirements are satisfied.

The bottom line is: talk to your tax adviser. You may be pleasantly surprised (which is OK).