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.
