United States: The Tax Court Weighs In: Lessee's "Project Costs" Payment Is Rental Income For Lessor

Monthly rental payments made by a lessee obviously constitute taxable rental income. However, rental income can encompass other types of payments, too. If lessors are not careful, they could end up on the hook for more tax liability than expected, as well as face significant penalties. One development company learned this lesson the hard way in the case of Stough v. Commissioner.

IRS Dispute

Stough Development Corporation (SDC) is a real estate development company that is 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's specifications.

In 2008, Talecris executed a 10-year lease with a limited liability company (LLC) 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.

Rental Income

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 was not rental income. Specifically, they asserted that the payment was not 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.

Court's Concession

The Tax Court conceded that situations could arise where an improvement made by a lessee is not 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 is 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 is not always as straightforward as it may seem as the IRS's definition of rental income can extend further than lessors might expect. A lessor's misunderstanding of what constitutes rental income could prove costly.

An Additional Note: Court Upholds $58,000 Accuracy-Related Penalty Against Lessor

The taxpayers in Stough v. Commissioner ended up shouldering a hefty accuracy-related penalty for their tax return mistakes. The IRC imposes a 20% penalty on any part of an underpayment attributable to a substantial understatement of income tax. A substantial understatement occurs if the amount of understatement for the taxable year exceeds the greater of 10% of the tax required to be shown on the return or $5,000. The penalty does not apply if the taxpayers had reasonable cause for their position and acted in good faith.

In Stough, the Tax Court rejected the taxpayers' argument that they had reasonable cause because they had relied on the advice of their CPA. It stated that unconditional reliance on a tax return preparer does not by itself constitute reasonable reliance in good faith — taxpayers have a duty to read their returns. Because they chose not to adequately review their tax return, the taxpayers were liable for the penalty.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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