In the case of Plentywood Drug Inc. et al. v. Commissioner, TC Memo 2021-45,[1] the IRS and the taxpayer were disputing whether rents paid by a C corporation to its shareholders were excessive.  While the Tax Court did not agree with the IRS’s determination of what amount was reasonable, the Court did find a portion of the rent paid was above a reasonable amount and denied that amount of the deduction.

The corporation in question ran a drug store in a very small town in Montana.  The Court described the operations of the store as follows:

Plentywood Drug has a single store on Main Street near the center of town. Its building has 8,125 square feet of retail space on the main level and 5,250 square feet of support area below. The store is a full-line pharmacy, but is also stocked as a convenience store for the community — it sells everything from groceries to toys. It uses the basement to store both inventory and business records. Robert Mann bought the building around 1978, and it is now co-owned in four equal shares by the Manns and the Eberlings.[2]

The corporation set the rent to the shareholders each year by oral agreement at the beginning of year.  The rents for the years in question were as follows:

The IRS argued that the rents over these years did not represent a reasonable amount to have paid for this space in this small town.  If that were the case, the excess rent would not be allowed as a deduction paid by the corporation, with those excess funds treated as a dividend.  The dividend would not be deductible to the corporation while the shareholders would have to pick these amounts up as dividend income.

Both the taxpayer and the IRS introduced experts to testify regarding the appropriateness of the rents charged for the drug store.  Normally the experts would try to find comparable properties and then compare those market rents with the amounts charged on this related party rental, with key disputes revolving most often around differences between the comparables and the lease being analyzed, as well as appropriate adjustments that should be made to take those differences into account.

However the Court noted that this case posed a number of special problems for finding such comparables given where the building was located:

The parties in these cases quickly realized that finding comparable properties in a town of 1,700 people in frontier Montana and then using them to come up with a fair market rent would be difficult. One problem right out of the chute is that Montana is a nondisclosure state. This means that real-estate data such as sales prices that appraisers can typically find in other states is legally confidential and simply not available. This issue is magnified in a town the size of Plentywood, which already has a limited number of even potentially comparable buildings. We heard entirely credible testimony that Montanans — perhaps especially Montanans in small communities — don’t commonly share details of their financial lives very readily with strangers.[3]

The Court found flaws with the methods that each expert used to account for these differences. The IRS used three government buildings in the town for which rental data was available, plus one other rental where data was available.  These included:

• Two government-subsidized multifamily residential buildings,

• The local post office, and

• A 625-square-foot commercial retail property.[4]

The government’s expert then attempted to adjust the rents for each property to take into account its different nature.  However, the Court found that the very different nature of rentals of government-subsidized multifamily residential buildings made them alike only in the fact that both they and the drugstore were rented--and the Court found the rents charged on those residential properties were not helpful in determining a proper rent for the retail business building.  The commercial rental property was also far smaller than the drugstore in question, and again the Court rejected using information from its rental to help determine a reasonable rental amount for the drugstore.

The taxpayer’s expert had decided to look for comparable properties in Williston, North Dakota, a town about one hour away from Plentywood, as well as in Plentywood due to the lack of available information on comparable rentals in Plentywood.  He found a number of properties for which he could obtain data in Williston, both because the location was not in Montana (and thus more data was considered public information) and the town was much larger than Plentywood, resulting in more buildings to choose from and what appears to be a more cooperative population that was less apt to worry about the outsider’s curiosity. 

But the Court didn’t find this approach helpful either, noting that Williston was a much larger community.  The opinion notes:

Although the properties McIvor found are very similar to Plentywood Drug’s retail space, we also find that the difference in market areas is very great. Williston has a larger population than Plentywood and rents there have been much affected by the oil boom. It’s possible that the boom also affected Plentywood, but neither party put in any solid proof of that — for example, evidence of a surge in population or business formation — into the record of these cases. We therefore do not accept the Williston properties as being reasonable comparables.[5]

The Court did note that both experts had used the Plentywood Post Office as a comparable, and the Court found that property both was located in the right place (in the small town, not in the much larger one) and the property itself was roughly comparable in use to the drug store.

After a discussion of that property and the one being rented, the Court concluded that a proper rent would be $15.90 per square foot for the main retail space and $8 per square foot for the basement storage space in the building.  This resulted in a total fair market value rent for each year of $171,187.50.

Thus the Court denied a deduction for just less than $20,000 for the rents paid in 2012 and 2013.

[1] Plentywood Drug Inc. et al. v. Commissioner, TC Memo 2021-45, April 26, 2021, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/tax-court-determines-fair-market-rent-for-pharmacy/59npq (retrieved May 1, 2021)

[2] Plentywood Drug Inc. et al. v. Commissioner, TC Memo 2021-45, pp. 3-4

[3] Plentywood Drug Inc. et al. v. Commissioner, TC Memo 2021-45, p. 8

[4] Plentywood Drug Inc. et al. v. Commissioner, TC Memo 2021-45, p. 11

[5] Plentywood Drug Inc. et al. v. Commissioner, TC Memo 2021-45, p. 18