“The Tax Court in Brief”
Plentywood Drug, Inc. | April 26, 2021 | Holmes| Dkt. No. 17753-16
Short Summary: The Tax Court was asked to decide whether rent paid by the Taxpayer was reasonable. The Taxpayer was owned by four related individuals (the “Shareholders”). The Shareholders owned the building where the the Taxpayer was operating. The Taxpayer paid rent of $83,584, $192,000, and $192,000 for 2011, 2012 and 2013, respectively.
The IRS disallowed certain rent deductions by the Taxpayer to the Shareholders because the IRS stated that the rent paid by the Taxpayer was greater than what the fair market rent would have been paid at an arm’s length transaction. The IRS recharacterized the excess rent as dividends, therefore, the Taxpayer would not be able to deduct the dividends.
The Taxpayer and the IRS introduced experts to testify regarding the fair market value of rent for the building. This case is unique because there were no comparable properties in this small town of 1,700 people.
The IRS does not often question the reasonableness of a rent agreed to by parties at arm’s length. When there is a close relationship between the lessor and lessee and there is no arm’s length dealing between them, the IRS will inquire into what constitutes reasonable rent.
Key Issues: What is the fair market rent for the building?
Primary Holdings: The Court, after considering each party’s expert witness, concluded that a proper rent would be $15.90 per square foot for the main retail space of the store and $8 per square foot for the basement storage space in the building, resulting in a total fair market value of rent each year of $171,187.50. The Court denied the Taxpayer a deduction of approximately $20,000 for tax years 2012 and 2013.
Key Points:
IRC section 162(a) allows a taxpayer to deduct the “ordinary and necessary” expenses it pays in carrying on a trade or business. The IRC specifically lists the rent paid by a business as one of these deductible expenses.
The expense for rent, to be ordinary and necessary, must be reasonable to be deductible. Any part of the rent that is unreasonable is not ordinary and necessary and thus not deductible.
The Court is not bound by the opinion of any expert witness and may accept or reject expert testimony in the exercise of its sound judgment.
When measurements were made and accepted by parties operating at arm’s length, the Court may rely on those figures in computing a proper price per square foot.