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Lump-Sum Payment toward Lessor's Construction Costs Was Rental Income in Year Received.

(Parker Tax Publishing June 6, 2015)

The Tax Court held that a lessee's lump sum payment toward lessor's construction expenses was rental income. Because the lease agreement only stated when rent was payable and did not specifically allocate rent to specific periods, the court held the entire payment was includible in the taxpayer's income in the year of receipt. Stough v. Comm'r, 144 T.C. No. 16.


Michael Stough is the sole shareholder of Stough Development Corp. (SDC), which is operated as an S corporation. SDC is a real estate development company primarily in the business of acquiring and developing real estate for use as plasma collection centers. Talecris Plasma Resources, Inc. (Talecris), operates plasma collection centers for the purpose of manufacturing and selling plasma protein therapeutics.

In 2006, SDC and Talecris entered into a development agreement in which SDC agreed to acquire property and construct a plasma collection center pursuant to Talecris' specifications. As part of the agreement, Talecris was required to lease the plasma collection center from SDC for an initial term of 10 years. In 2007, SDC acquired a parcel of real property in North Carolina and began development. In 2008, Talecris moved into the new plasma collection center.

The lease required Talecris to pay monthly rent based on "project costs" that SDC incurred in acquiring and developing the plasma collection center. The lease allowed Talecris to pay a lump-sum for any portion of the project costs. Because Talecris' rent was a function of project costs, a lump-sum payment would reduce the project costs, and consequently, reduce the amount of rent that Talecris owed under the lease. In 2008, a month before the lease was executed, Talecris made a $1 million lump-sum payment.

Talecris issued a Form 1099-MISC to Stough, reporting rents of $1,151,493 for 2008, representing $151,493 in monthly rent for the plasma collection center along with the $1 million lump-sum payment.

Stough and his wife filed a joint return for 2008. On Schedule E they reported rents received of $1,151,493 in connection with the plasma collection center and claimed a $1 million offsetting "contribution to construct" expense. In 2011, the IRS issued a notice of deficiency for 2008, disallowing the $1 million deduction. The Stoughs disputed the determination of deficiency.

Lump Sum Payment Was Rental Income

Under Reg. Sec. 1.61-8(c), if a lessee pays any of the expenses of his lessor, such payments are additional rental income of the lessor. If a lessee places improvements on real estate as a substitute for rent, such improvements may become rental income to the lessor. Whether or not improvements result in rental income depends upon the intention of the parties.

The Tax Court noted that although Stough initially reported the $1 million lump sum payment as rental income on one of his Schedules E, before the court he argued that this was a reporting error and that the amount was not rental income for 2008. Instead, he claimed that the $1 million lump sum payment to SDC was meant as reimbursement for leasehold improvements to the plasma collection center. Stough argued that his and Talecris' subjective intent regarding the payment should control and that the court should find the payment was a reimbursement, not a substitute for rent.

The court did not find that the parties intended the payment to be a reimbursement, noting that Talecris made no leasehold improvements. Rather, the court found the lessee exercised its option under the lease to pay $1 million in order to reduce the amount of "project costs" for purposes of calculating annual rent, and furthermore, both parties had treated the amount as rent before the IRS examined the Stoughs' 2008 return.

The court found that the lump sum payment: (1) was made pursuant to the terms of the lease, (2) was optional at the election of the lessee, (3) was to "reimburse" the lessor for "project costs" incurred and paid by the lessor in bringing the property into existence, and (4) reduced the lessee's future rents otherwise due. Given those findings, the court held the $1 million lump sum payment fell within the purview of Reg. Sec. 1.61-8(c), as the lessee's payment of the lessor's expenses and therefore was properly treated as rental income.

Lump Sum Rent Could Not Be Recognized over Lease Term

Code Sec. 467 provides methods for allocating rents pursuant to a "Section 467 rental agreement." In order to qualify as a Section 467 rental agreement, an agreement must have:

(1) increasing or decreasing rents, or deferred or prepaid rents and

(2) aggregate rental payments exceeding $250,000. Code Sec. 467(d)(2); Reg. Sec. 1.467-1(c)(1).

Under Code Sec. 467(b), the determination of the amount of the rent under any Section 467 rental agreement which accrues during any taxable year is made by allocating rents in accordance with the agreement. Under Reg. Sec. 1.467-1(c)(2)(ii)(A)(1), if a rental agreement provides a specific allocation of fixed rent, the amount of fixed rent allocated to each rental period during the lease term is determined by the rental agreement.

With respect to Section 467 rental agreements that do not provide for adequate interest on prepaid or deferred rent, the fixed rent for any rental period is the proportional rental amount (Reg. Sec. 1.467-1(d)(2)(ii)). The proportional rental amount for a rental period is the amount of fixed rent allocated to the rental period under the rental agreement multiplied by (1) the sum of the present values of the amounts payable as fixed rent and interest, over (2) the sum of the present values of the fixed rent allocated to each rental period (Reg. Sec. 1.467-2(c)(1)).

Stough argued that, if the $1 million lump-sum payment was determined to be rental income (which it was), he was entitled to report the payment ratably over the 10-year life of the lease pursuant to Code Sec. 467, and that only a portion of the payment was includible as income for 2008. The Tax Court stated this was an issue of first impression for the court.

The court found that the lease did not "specifically allocate" fixed rent to any rental period within the meaning of Reg. Sec. 1.467-1(c)(2)(ii)(A). However, the court noted the lease did provide for a fixed amount of rent payable during the rental period (i.e., rent payable pursuant to the terms of the lease). Accordingly, in the absence of a "specific" allocation in the rental agreement, the court determined the amount of rent payable in 2008 must be allocated to Stough's 2008 rental period pursuant to Reg. Sec. 1.467-1(c)(2)(ii)(B), which provides that "the amount of fixed rent allocated to a rental period is the amount of fixed rent payable during that rental period."

Stough additionally argued the proportional rental method under Reg. Sec. 1.467-1(d)(2)(ii) was applicable and would allow him to include only a ratable portion of the $1 million payment as rent in 2008 because the payment constituted prepaid rent.

The court pointed out that the proportional rental method would only apply if the Section 467 rental agreement did not provide for adequate interest on fixed rent, which would occur if the agreement had prepaid rent. The court noted that under Reg. Sec. 1.467-1(c)(3)(ii), a rental agreement has prepaid rent if 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.

The court found the cumulative amount of rent payable by Talecris as of the close of the 2008 calendar year was $1,151,493 (the lump-sum payment plus monthly rent). The court noted that although the record did not include the exact amount of rent payable by Talecris for the 2009 calendar year, Talecris did have rent payable during 2009 based on the mathematical formula contained in the lease. The court determined that the cumulative amount of rent payable as of the close of 2008 ($1,151,493.18) would not exceed the cumulative amount of rent allocated as of the close of 2009 ($1,151,493.18 plus rent payable during 2009). Accordingly, the court found that the Section 467 rental agreement did not have prepaid rent.

Because the lease did not provide for prepaid rent, the court deemed it to have "adequate interest on fixed rent" under Reg. Sec. 1.467-2(b), and thus the proportional rental method was unavailable to allow the taxpayer to spread the lump sum over the term of the lease.

OBSERVATION: Stough fruitlessly attempted to argue that he could use the "constant rental accrual method" of Reg. Sec. 1.467-3(d), but the court noted that method was intended to allow the IRS to rectify tax avoidance situations and could not be used in the absence of a determination by the IRS that the rental agreement was disqualified, which the IRS had not made here.

Because the lease did not provide for specific allocation of the rental payments, and other methods to apportion the payment over the term of the lease were inapplicable, the Tax Court held that Stough was required to include as rental income in 2008 the entire $1 million lump sum payment.

For a discussion on Section 467 rental agreements, see Parker Tax ¶ 71,140. (Staff Editor Parker Tax Publishing)

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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