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Tax Court Holds Lump Sum Payment Is Rental Income in Year Received and Sustains Penalty


August 2015

Synopsis

In Stough v. Commissioner (144 T.C. No. 16), the Tax Court upheld a deficiency determination and sustained an accuracy-related penalty regarding a taxpayer’s treatment of a lump-sum payment received under the terms of a lease agreement.

Issue

The taxpayer in Stough was the sole owner of an S corporation real estate development company. The S corporation entered into an agreement with a party to construct and lease a facility. The lease agreement included a provision allowing the lessee to make lump-sum payments to reimburse the S corporation for the cost of constructing and improving the facility. If and when these payments were made, they would be used to reduce future rental payments. The lessee made a $1 million lump sum payment to the S corporation pursuant to the lease provision. The lessee issued a Form 1099-MISC to the S corporation with the payment reported as rent.

The taxpayer’s return was prepared by a CPA. The taxpayer included the $1 million lump sum payment on Schedule E of Form 1040 as rent, claimed a $1 million expense, and reduced its basis in the facility by $1 million. The IRS issued a notice of deficiency disallowing the $1 million deduction. It then increased the basis in the facility by $1 million, and imposed a 20% accuracy-related penalty based on a substantial understatement of tax.

The taxpayer argued that the $1 million payment should be viewed in one of two ways: (1) the payment was not rental income but a reimbursement of construction costs, or, (2) in the alternative, if the payment was rent, under §467 the taxpayer should be allowed to report the payment over the 10-year life of the lease instead of in the year received. The taxpayer, further, maintained that the substantial understatement penalty should be removed because the taxpayer had used an experienced CPA to prepare the return.

The Tax Court rejected the taxpayer’s arguments and determined that the entire $1 million payment was taxable as rent in the year received. It further ruled that the taxpayer had not truly relied on the advice of the CPA, therefore, the 20% substantial understatement penalty was sustained.

The Tax Court reasoned that the lump sum payment was paid pursuant to the terms of the lease agreement and was an optional payment by the lessee. The lessee, under the lease agreement, was fully responsible for payments associated with improvements to the property. The lessee’s lump sum payment relieved the lessor of an obligation and, since the lessor received an economic benefit from the payment, it should be construed as a rent payment.

The Tax Court rejected the taxpayer’s assertion that, if the lump sum payment is rent, then §467 should control the recognition of rent and allow the taxpayer to report the rent over the 10 year term of the lease. The Tax Court also held that, because the rental agreement did not contain a specific rent allocation schedule, and in the absence of such a provision, the rent payable in 2008 is the amount allocated to that period – the entire $1 million.

The taxpayer’s understatement of tax falls within the requirements for a substantial understatement penalty pursuant to §6662. The penalty is imposed unless the taxpayer can show that an exception applies to a unique set of facts. The taxpayer in Stough argued that the understatement was the result of reasonable cause based on reliance on a competent CPA who had sufficient expertise to justify such reliance.

The Tax Court held that the taxpayer did not actually rely upon the CPA, noting that the taxpayer admitted to only briefly reviewing the return. The CPA also testified that he did not sit down with the taxpayer to discuss the details of the return before it was signed. The Tax Court also noted that a taxpayer is not relieved of their duty to read the return. The Tax Court stated that had the taxpayer properly reviewed the return the fact that the $1 million payment was not fully deductible in the year of payment would have been detected.

Contact

For more information, please contact Richard Shevak, Director, at richard.shevak@cohnreznick.com or at 862-245-5029.

To learn more about CohnReznick’s Tax Practice, please visit our webpage.


 
Any advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues. Nor is it sufficient to avoid tax-related penalties. This has been prepared for information purposes and general guidance only and does not constitute professional advice. You should not act upon the information contained in this publication without obtaining specific professional advice. No representation or warranty (express or implied) is made as to the accuracy or completeness of the information contained in this publication, and CohnReznick LLP, its members, employees and agents accept no liability, and disclaim all responsibility, for the consequences of you or anyone else acting, or refraining to act, in reliance on the information contained in this publication or for any decision based on it.
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