1. Tax Memorandum
From: Corey L. Puckett
Subject: Lease Agreements and Rental Income
Sam is engaged in the business of real estate development and leasing. In 2013
Sam purchased land and began construction of a facility to be leased by ABC, Inc.
ABC (Lessee) signed a ten year lease which provided for monthly rent payments
based upon project costs (costsincurred by the Lessorto acquire land and construct
a facility). The lease agreement gave the Lessee the option to make an upfront,
lump-sum payment to the Lessor as reimbursement for a portion of the project
costs. Thelease agreement provided that the optional lump-sum payment would
reduce project costand, thus, reduce the calculated amount of future monthly
Lessee occupied the facility and began paying rent on March 1, 2014. The Lessee
exercised the option in March 2014 and made a $1 million lump-sum payment to
Lessor. Lessorused the lump-sum payment to reduce the balance of the
outstanding construction loan.
2. Lessee issued to Lessora Form 1099-MISC which reported as rents for 2014 the
sum of $150,000 (sum of monthly rent payments for March - December of 2014)
plus the $1 million lump-sum payment for total rent of $1,150,000.
In February 2015, Lessorasked Lessee to file an amended Form 1099-MISC and
to report rent payments of $150,000 for 2014 and a $1 million lump-sum
reimbursement of "project costs." TheLessee issued the amended 1099-MISC as
requested by the Lessor.
Does Sam have to report the lump sum of $1,000,000 as income in the year of
Sam has to report all $1,000,000 as income in the year of receipt. The structure of
the lease agreement makes the $1,000,000 a prepaid rent expense for the Lessee
and $1,000,000 prepaid rental income for Sam. Sam should have structured the
lease agreement differently so that the $1,000,000 wouldn’t be prepaid rental
income. One way he could have done this is:
1. Sam could have asked ABC to pay $1,000,000 for the project costs,
separating the payment completely from the lease agreement and rent. Now,
there isn’t a quid-pro-quo substancewithin the agreement, which the IRS
would stand by as prepaid rental income. But instead, ABC paid $1,000,000
3. directly to the contractor performing the project, and the lease agreement
would have rent payments with no ties to a reduction in rent expense.
Current Internal Revenue Code,SEC. 467.CERTAIN PAYMENTS FOR THE USE
OF PROPERTYOR SERVICES
467(a)AccrualMethod on Present Value Basis.—
In the case of the lessor or lessee under any section 467 rental agreement, there
shall be taken into account for purposes of this title for any taxable year the sum
the amount of the rent which accrues during such taxable year as determined under
467(b)(1)Allocation follows agreement.—
Except as provided in paragraph (2), the determination of the amount of the rent
under any section 467 rental agreement which accrues during any taxable year
shall be made—
by allocating rents in accordancewith the agreement, and
4. by taking into account any rent to be paid after the close of the period in an amount
determined under regulations which shall be based on present value concepts.
467(b)(2) Constantrental accrualin case of certain tax avoidancetransactions,
In the case of any section 467 rental agreement to which this paragraph applies, the
portion of the rent which accrues during any taxable year shall be that portion of
the constant rental amount with respect to such agreement which is allocable to
such taxable year.
The term “constantrental amount” means, with respectto any section 467 rental
agreement, the amount which, if paid as of the close of each lease period under the
agreement, would result in an aggregate present value equal to the present value of
the aggregate payments required under the agreement.
467(f)ComparableRulesWhere Agreement for Decreasing Payments.—
Under regulations prescribed by the Secretary, rules comparable to the rules of this
section shall also apply in the case of any agreement where the amount paid under
the agreement for the use of property decreases during the term of the agreement.
5. Tax Court Regulars(Current), Michael H. Stough and BarbaraM. Stough v.
Commissioner., U.S. TaxCourt, CCH Dec. 60,317, 144 TC 16, (Jun. 2, 2015)
Lessors who entered into a 10-year lease agreement were obligated to treat a lump-
sum payment from the lessees as reportable rental income for the year of receipt
and were not allowed to allocate the payment proportionately over the life of the
lease under CodeSec. 467. Because the lease only stated when rent was payable
and did not provide a specific allocation of fixed rent, the amount of fixed rent
allocated to a rental period was the amount of fixed rent payable during that rental
period. Therefore, the lessors were required to report the entire lump-sum payment
made pursuant to the terms of the lease as rental income for the year of receipt.
Further, the constant rental accrual and proportional rental accrual methods were
inapplicable to the lease. The constant rental accrual method to spread the
individuals’ rental income to other years did not apply to the lease because it was
intended to allow the IRS to rectify tax avoidance situations, and the regulations
provide that this method may not be used in the absence of a determination by the
IRS. The proportional rental accrual method did not apply because the lease did
not have prepaid rent and provided for adequate interest on fixed rent. The
individuals were liable for an accuracy-related penalty under CodeSec. 6662(a)
due to substantial understatement of income tax