Related Party Leasehold Improvements Tax Trap


Facts: Real estate is owned by one or more shareholders who allow their corporation use of the land and improve it.  The corporation, without benefit of long-term leases, continues to improve its shareholders' real estate with upgrades to buildings and infrastructure.


Tax Trap: This creates several complex tax traps.


Improvements as a substitute for rent - Under US Treasury Regulation 1.61-8(c), the owner landlord includes in gross income the fair market value of improvements placed on the property by the lessee.


This can only be remedied prospectively.  However, the result is a 3 to 6 year tax exposure equal to the fair market value of those improvements.  The extended period from 3 to 6 years depends upon whether or not the value of the annual improvements exceeds 25% of your reported income. 


For example, if the shareholders normally report $75,000 of income, improvements greater than 25% or $19,000 would result in an extended statute of limitations from the normal 3 years to 6 years.


DSB&Co is experienced in the designing the economics of a related party leasing.


Beecham, Inc. v. United States

A key case on the issue is Beecham, Inc. v. United States, KTC 1973-32 (E.D.Tenn. 1973).  The judicial standard of measurement is "arm's-length rental charge" and the validity of the related regulations have been well affirmed.


Actions Necessary to Remedy

Resolution involves establishing what constitutes a fair market rent on the underlying land and the appropriate lease term.  Though resolving the problem prospectively can be done, should there have been a history of low rents; a written lease may be quite detrimental upon an IRS audit.


The materiality of this would depend upon the dollar amount of improvements.  Assuming for example, that the capital improvement for the preceding four years made by a corporation amount to $X million, the potential federal tax burden before interest, penalties and State taxes, all of which can add another 40% or so, is approximately 35% of the capital improvements.


Personal Use by Employees of Employer's Real Property

Personal use by employees of employer's real property constitutes taxable compensation to employee. Subject to a number of narrowly carved out exceptions, the fair market value rent of living accommodations provided by the corporation is taxable compensation to employees subject to W-2 payroll tax withholdings. 


DSB&Co recommends when encountering this situation that a review of statutory exemptions be undertaken that might apply to the circumstances and that employment agreements emphasize those attributes.  One exception we frequently utilize is the duties of on site security guard and other similar requirements of employment to reside on the business premises.  However, that may not encompass everyone living under a corporation's roof.  For the rest, we would likely recommend some compensation be attributable to their living accommodations in order to avoid the "pigs get slaughtered" problem. 


Similar rules apply to the personal use of corporate vehicles.


From a materiality view point, this is relatively minor but a high priority for an examining agent wherein a dispute of fair value of accommodations would ensue. 

In your CPA firm's experience, what is the most material overlooked deduction in the estate, gift and trust income tax area

If you have any questions, do not hesitate to contact the professionals at Dana S. Beane & Company, PLLC



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