In the case of Stough v. Commissioner, 144 TC No. 16, the taxpayer was looking to argue that a payment of $1 million received during the year was either not rental income (being a reimbursement of construction costs) or, if it was rental income, it should have been reported over the entire 10 year life of the lease.  And if neither of those were true, at least the taxpayer should be able to avoid a substantial understatement penalty because the taxpayer had relied upon an experienced CPA to prepare the return in question.

Unfortunately for the taxpayer, the Tax Court did not agree with any of those assertions, determining the entire $1 million payment was taxable rent in the year received and the taxpayer had not shown he had properly relied on the CPA’s work.

This case involved a piece of property that was owned by the taxpayer’s S corporation.  The corporation agreed to acquire and improve the property for use by a tenant that would enter into a 10 year lease on the property. 

The tenant’s annual rent payments were based on a formula that was based on “project costs” the landlord incurred in acquiring the property and making the improvements.  The lease provided that, at the tenant’s option, a lump sum payment could be made under the lease that would serve to reduce the “project costs” used in the calculation of the rent.  In 2008, a few months after occupying the property, the tenant made a $1 million payment under that option.

The tenant issued the landlord a Form 1099MISC showing rents for the year of $1,151,493.18 for 2008, which consisted of the $1,000,000 payment along with $151,493.18 of monthly rents paid.  The CPA preparing the return reported the entire $1,151,493.18 as rental income, but reported an expense of $1,000,000 listed as “contribution to construction.”

The IRS in 2010 began an exam of the return.  While the entire $1,151,493 had been shown as rent, the taxpayer on exam argued that, in fact, the $1,000,000 was not actually rent for the year—thus arguing for the removal of both that amount of rent and $1,000,000 contribution to construction.  The IRS agreed with striking the contribution to construction expense, but did not accept that the $1,000,000 should not be reported as rent.

After the exam began the taxpayer requested that the tenant issue a revised Form 1099MISC showing only the $151.493.18 as rent for the year.  The tenant agreed to do so and did file just such an amended Form 1099MISC.  Despite the revised Form 1099MISC the IRS stood firm in their position that the payment was rent.

The taxpayer argued that this was “really” a payment by the tenant for leasehold improvements and that, therefore, there was no rent paid.  The Tax Court, however, noted that the payment was made under the terms of the lease document and was an optional payment on the part of the lessee.  The lessor, under the terms of the lease, was wholly liable for the amounts paid to improve the property and this payment effectively was used to relieve them of that obligation.  As such the landlord received an economic benefit from the payment—and the Tax Court held that, at this point, regardless of the intent of the parties the payment constituted rent.

The Court rejected the taxpayer’s argument that intent should control because this was not a case of improvements made by the tenant.  The tenant made no improvements, but simply exercised its option under the lease to make a $1 million payment that would serve to reduce future payments under the lease.

The taxpayer argued that if the payments were rent, then IRC §467 should serve to allow the taxpayer to report the $1 million over the 10 year term of the lease.

IRC §467 potentially impacts timing of recognition for rental agreements where rental payments increase under the agreement and aggregate rental amounts exceed $250,000.  In this case the parties all agree the rent meets these initial requirements.

IRC §467(b) provides the rules for recognition under certain agreements that meet the base requirements of §467.  The general rule is described under §467 in this fashion:

(b) Accrual of rental payments

(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--

(A) by allocating rents in accordance with the agreement, and

(B) 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.

The Courts that both parties agreed that (B) did not apply to this situation—so now the Court turned to (A) to determine how to “allocate rents in accordance with the agreement” for this purpose.

The Court determined that under the rules provided for in Reg. §1.467-1(c)(2)(ii) the rental agreement did not provide for specific allocation schedule and, therefore, in the absence of such an agreement that, under Reg. §1.467-1(c)(2)(ii)(B) the amount of rent payable in 2008 would be the amount allocated to that period.  Under this view the entire $1 million, paid under the option in 2008, would be rent for that period.

The taxpayer noted that is §467(b) provides for other treatments and argued they should be allowed to use the constant rental method provided for in IRC §467(b)(2).  The Tax Court noted that this provision was added specifically to allow the IRS to deal with tax avoidance transactions and the regulations provide explicitly that this method “may not be used in the absence of a determination by the Commissioner”—and the IRS wasn’t arguing here that the taxpayer must use the constant rental method.  As well, the method applies only to disqualified leasebacks and long-term agreements as defined by §467—and this lease was neither. 

The taxpayer argued next that they should be reporting under the proportional rental method as described by Reg. §1.467-1(d)(2)(ii).  The Court notes that, under that regulation, this method would apply if the rental agreement does not provide adequate interest on fixed rent. [Reg. §1.467-2(a)(2)]  A rental agreement provides adequate interest under these rules if there is no deferred or prepaid rent as described in Reg. §1.467-1(c)(3).

The Court turned to those rules and noted that an agreement only 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 notes we’re back to the original problem under §467(b)—the rental allocated as of the close of the year included the $1,000,000, thus that amount did not constitute a prepayment.  Rather the amount payable as of the close of 2008 was equal to the amount allocated as of the end of 2008.

Thus, the Court found, the taxpayer gets not relief under §467 and rather ends up having to report the entire amount as rental income on the 2008 return.

But what about penalties?  The taxpayer had the return prepared by an experienced CPA who had “backed out” the $1,000,000 payment as a contribution to construction.

The tax that the Court found to be understated met the mechanical requirements for a substantial understatement subject to a 20% penalty under IRC §6662—the amount of tax was greater than the greater of 10% of the tax required to be shown on the return or $5,000.  Thus the penalty would apply unless the taxpayers could show they met an exception to the imposition of the penalty.

One such exception is that the understatement was due to reasonable cause, for which they would be eligible for relief under IRC §6664(c)(1).  The taxpayers argued they had relied up the advice of their CPA who had prepared the return as noted.

The Court notes that to show reasonable cause based on reliance on a professional the taxpayer must show three things:

• The adviser was a competent professional who had sufficient expertise to justify reliance,
• The taxpayer provided necessary and accurate information to the adviser, and
• The taxpayer actually relied in good faith on the adviser's judgment.

The Court agreed the CPA in question was a competent professional with sufficient expertise to justify reliance.  However the Court found that he hadn’t truly relied upon the CPA.

The taxpayer had testified that he only “briefly” reviewed the return for the year in question before filing it.  The CPA testified that he did not sit down with the taxpayers to discuss the return before it was signed.  The Court notes that “[u]nconditional reliance on a tax return preparer or C.P.A. does not by itself constitute reasonable reliance in good faith; taxpayers must also exercise ‘[d]iligence and prudence.’”

Even if the taxpayers provided complete information to a competent professional, they still have a duty to read the return and will not be relieved of responsibility if a taxpayer’s cursory review of the return would have revealed errors.

In this case the Court found that the taxpayer’s background as a successful businessman indicated that if he had reviewed the return, he would have noticed the $1 million deduction claimed for contributions to construction.  He would have known that such money, even if related to the property in question, would not have represented a fully deductible expense in the year paid.

As the Court noted, at trial the taxpayer wasn’t claiming that there could be a $1 million deduction for expenses related to the building in 2008.  Rather his position was that the $1 million should not have been reported as rental income. 

The Court’s conclusion here is interesting and, potentially, troubling.  Many advisers, upon concluding that the $1,000,000 should not have been reported as rent, would nevertheless want to report the entire rent shown on the Form 1099MISC in order to avoid the issuance of  CP2000 and then would report an offsetting expense so that the net reported on Schedule E now comports with their view of the proper taxation.  However, in this case the Court focused on the fact that the $1,000,000 itself could not have been a proper deduction under any view.

What’s not clear is if things might have been different if the description on the return had clearly indicated that it was meant to be a reduction of rental income or if a detailed disclosure had been attached to the return indicating that the position was being taken that the Form 1099MISC had not been properly prepared.

Certainly at a minimum this case should cause advisers to carefully consider how to report in cases where there is a dispute regarding amounts shown on a Form 1099—and especially how to disclose that position on the return.