IRS Challenges Rent In A Small Town

Let’s look at a case involving rent.

What sets this up is a C corporation in Montana.

A C corporation means that it pays its own tax. Contrast this with an S corporation, which (with rare exception) passes-through its income to its shareholders, who then combine that income with their own income (W-2, interest and dividends) and pay tax personally.

As a generalization, a tax advisor working with entrepreneurial clients is much more likely to work with S corporations (or LLCs, an increasingly popular choice). The reason is simple: a C corporation has two levels of tax: once to the company itself and then to the owners when distributed as dividends. Now that may not be an issue to a Fortune 1000, some of which are larger than certain countries and themselves are near-permanent entities - expected to outlive any current corporate officer or investor. It however is an issue to a closely-held company that will be lucky to transition one generation and unlikely to transition two.

Plentywood Drug is a Montana corporation that operates the only pharmacy in Plentywood, Montana and serves four counties spanning 7,200 square miles.

The company has four owners, representing two families.

It leases a building owned by its four owners.

COMMENT: So far, there is zero unusual about this.

The company paid the following rent:

           2011                       $ 83,584

           2012                       $192,000

           2013                       $192,000

The IRS did not like this one bit.

Why not?

Let’s go tax nerd for a moment. The IRS said that the company was paying too much in rent. Rent is deductible. Excess rent is considered a dividend and is not deductible. The corporation would lose a deduction for its excess rent. The owners however received $192,000, so they are going to be taxed on that amount. How will they be taxed if the IRS ratches-down the rent? The excess will be considered dividends and taxed to them accordingly.

Remember: a C corporation does not get a deduction for dividends. The IRS gets more tax from the company while the individual taxes of the four owners stays the same. It’s a win for the IRS.

An S corporation does not have this issue, as all income of the S is taxed to its owners. This is another reason that tax advisors representing entrepreneurial wealth prefer working with S corporations.

How does the IRS win this?

Well, it has to show that $192,000 is too much rent.

Problem: the town of Plentywood has 1,700 people.

Another problem: Montana is a nondisclosure state, meaning real estate data – such as sales prices – is legally confidential and simply not available.

The IRS brought in its valuation specialist. Third problem: Montanans do not tend to share financial information easily with strangers.

The IRS expert remarked that that he did not identify himself as an IRS agent while he was in Plentywood.

Probably for the best.

Then the IRS expert made a fateful decision: he would base his appraisal solely on Plentywood data.

Well, that should take about half a day.

He looked at the post office, two apartment buildings and a 625-square-foot commercial space.

He did the best he could to compensate by making adjustments: for commercial versus residential, for the safety of the Post Office as a tenant, for Aaron Rodgers possibly leaving the Packers.

The two families brought in their specialist, who supplemented his database by including Williston, North Dakota – the “big town” about an hour away and with a population about eight times the size.

The IRS argued that Williston was simply not comparable.

Here is the Court:

We therefore do not accept the Williston properties as being reasonable comparisons.”

Oh oh.

The two families argued that the IRS specialist was mixing tamarinds and eggplants.

Here is the Court:

His expert used two residential properties in his analysis. Government-subsidized multifamily residential housing is like a retail drugstore in that both are rented. But not in much else.”

You can tell the Court was frustrated.

How about the post office? Both sides used the post office.

Yet even though both sides agree that the post office is comparable, they disagree about the number of square feet it has.”

The Court – having to do something – decided that fair rent was $171,187.

The IRS then wanted penalties. The IRS always wants penalties.

What for?

The Commissioner alleges that the first cause on this list – negligence or disregard of rules or regulations … - applies to Plentywood Drug ….”

The Court squinted and said: What? You brought a trial, the rent turned out to be within $20 grand of what the families deducted in the first place, we have heard far too much about appraising properties over frontier America and you have the nerve to say that there was negligence or disregard?

The Court adjusted the rent and nixed the penalties.

Our case this time was Plentywood Drug Inc v Commissioner, T.C. Memo 2021-45.