Passive Activity Self-Rental Rule Applies to S Corporations
Kadir Sunardio, CPA, CFP®
If you own property and a business, there is an obvious temptation to lease that property to the business. However, be careful—you risk triggering the self-rental rule and catching the eye of the IRS. One creative couple tried to get around this by using an S corporation to lease their property to their business; however, their effort fell flat.
Self-Rental Rule in a Nutshell
The Internal Revenue Code (IRC) generally prohibits taxpayers from deducting passive activity losses (PALs). It defines “passive activity” as any trade or business in which the taxpayer does not materially participate. Rental real estate activities generally are considered passive activities regardless of whether the taxpayer materially participates.
A PAL is the amount by which the taxpayer’s aggregate losses from all passive activities for the year exceed the aggregate income from all of those activities. A PAL can usually only be used to offset passive income (although the IRC does provide a few exceptions).
The self-rental rule in IRC Section 469 applies when you rent property to a business in which you or your spouse materially participates. Under the rule, any rental losses are still considered passive, but the rental income is deemed nonpassive.
That means your rental profits cannot be offset by passive losses, and the rental losses generally can offset only passive income. You essentially suspend the tax benefits from current rental losses unless you have passive income.
Real-Life Example of the Negative Consequences
A couple in Texas owned two businesses: BEK Real Estate Holdings, an S corporation, and BEK Medical, Inc., a C corporation where the husband worked full-time. The S corporation leased commercial real estate to the C corporation. Neither the husband nor the wife materially participated in BEK Real Estate or otherwise engaged in a real property business.
In 2009 and 2010, BEK Real Estate had net rental income of $53,285 and $48,657, respectively, solely from the rental of property to BEK Medical. The couple reported those amounts as passive income on their 2009 and 2010 tax returns. They offset the income with passive losses from other businesses. The IRS, however, reclassified the rental income as nonpassive and disallowed the passive losses they claimed against the rental income for 2009 and 2010.
As a result, they owed more than $26,000 in taxes on the rental income for the two tax years.
They appealed to the U.S. Tax Court. When the court ruled in favor of the IRS, the couple appealed to the Fifth Circuit Court of Appeals.
An Unusual Challenge
The couple argued that the self-rental rule did not apply because Sec. 469 does not define “taxpayer” to include S corporations. And, they claimed, even if it did, BEK Real Estate did not materially participate in BEK Medical.
The Fifth Circuit Court acknowledged that Sec. 469 does not refer to S corporations at all: “The statute specifically applies to ‘taxpayers’ who are individuals, estates, trusts, closely-held C corporations and personal service corporations.” However, the appellate court agreed with the Tax Court that the provision did not need to specifically refer to S corporations because S corporations are merely pass-through entities; the individual shareholders in an S corporation are the ultimate taxpayers, not the entity.
Therefore, the Fifth Circuit found that an S corporation is nit really a taxpayer. And, because S corporations do not pay taxes directly, Sec. 469 had no need to include them in its list of potential “taxpayers.”
The material participation argument regarding the S corporation’s level of participation also failed. The couple were the taxpayers, so the proper focus was not on the S corporation but on the couple. The husband, who worked full-time for the C corporation, indisputably materially participated in its business.
Renting property to a business in which you materially participate can be a lose-lose proposition when it comes to your taxes. Your financial advisor can help you devise a more beneficial arrangement.
Sidebar: A Potential Reprieve from the Self-Rental Rule
You may be able to avoid the negative tax repercussions of Internal Revenue Code (IRC) Section 469’s self-rental rule by “grouping.” The IRC allows you to group your separately owned rental building with your business to treat them as one activity for purposes of the passive loss rules if they constitute an “appropriate economic unit.” The regulation determines this based on factors such as common ownership and control, types of activities and location. As long as you materially participate in the business (and the business is not a C corporation) the rental activity will not be treated as passive.
To take advantage of this option, you must own both the rental property and the business. You could also use grouping if the rental activity is “insubstantial” (a term undefined by the regulations) in relation to the business activity.
The Tax Court Weighs In: Lessee’s “Project Costs” Payment is Rental Income for Lessor
Anita Wescott, CPA
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.
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.
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.
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.