Wednesday, September 19, 2012

Tax Court allows deduction for rent paid to children’s S corp

Doeren Mayhew 

The Tax Court has held that a taxpayer's sale of an office building to his adult children, and his payment of rent for use of offices in the building, were bona fide transactions that had economic substance. The court rejected the IRS's argument that the transaction was tax-motivated and that the rental payments were not deductible. The court's opinion demonstrates that transactions between family members, such as a sale of real estate, can be respected for tax purposes if the facts demonstrate that the transaction was bona fide and had a business purpose.

Sale and rental of building
The taxpayer operated a profitable law firm and owned the building in which the law firm was located. He reported the law firm's operations on a Schedule C, Profit or Loss From Business, used by a sole proprietor. In 2003, he sold the building to an S corp owned by his two sons. In subsequent years, he paid rent of $27,000 to $30,000 a year to the S corp and deducted the rental payments on the law firm's Schedule C. The parties had no written rental agreement.

The IRS claimed that the sale of the building was solely tax-motivated, allowing the taxpayer to transfer the building at less than fair market value, increase the building's depreciable basis, avoid depreciation recapture, and increase the law firm's deductions significantly, while passing a significant family-owned asset to the next generation.

The Tax Court agreed that a transaction may be disregarded as lacking in economic substance if it has no legitimate business purpose and is solely tax-motivated. But if there is a legitimate business purpose, the transaction will have economic substance, even if it is also motivated by saving taxes.

Economic substance
The Tax Court noted that the sons had income of their own, that they had obtained and signed for the loan used to purchase the building, and had made the mortgage payments on the building. Furthermore, there were legitimate business reasons for the transfer: the taxpayer did not want to deal with tenants or with maintenance of the building, and the sons viewed the sale of the building as a natural step in their father's eventual retirement.

The court cautioned that certain issues could have required more scrutiny but were not raised by the IRS. These included whether the building purchase price was arm's-length, whether all of the law firm's deductions were proper, and whether the sons were charging a fair market rent. The IRS had only argued lack of economic substance. Since the court rejected this argument, it allowed the law firm to deduct "payments actually made."

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