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Tax Court sustains IRS penalty for treatment of lump sum payment

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The Tax Court in Stough v. Commissioner (144 T.C. No. 16) sustained an accuracy-related penalty for a taxpayer’s treatment of a lump sum payment received under the terms of a lease agreement.

The taxpayer in Stough was the sole shareholder of an S corporation real estate development company. The S corporation entered a contract with an unrelated third party to construct a facility that would be leased to the third party. Under the lease agreement, rent was calculated in part based on a formula that accounted for costs the S corporation incurred in constructing the facility. The lease agreement also included a provision allowing the lessee to make a lump sum payment to reimburse the S corporation for costs incurred in constructing the facility. According to the formula in the lease agreement, if such a payment was made, future rental payments would be reduced. The S corporation received a $1 million lump sum payment under the lease provision. The third party issued a Form 1099-MISC to the S corporation reporting the lump sum payment as rent.

The taxpayer accounted for the $1 million lump sum payment on Schedule E of Form 1040 by including the $1 million as rent but also claiming a $1 million “contribution to construct” expense.  The taxpayer also reduced its basis in the facility by $1 million. The taxpayer’s return was prepared by a CPA. After the IRS began its examination, the taxpayer asked for and received a corrected Form 1099-MISC, which recharacterized the $1 million payment as a “buy-down reimbursement” of construction costs. The IRS issued a notice of deficiency disallowing the $1 million offsetting deduction but also increasing the basis in the facility by $1 million and allowing an additional amount of depreciation for the year. The IRS also imposed a 20% accuracy-related penalty attributable to a substantial understatement of tax.  

The Tax Court rejected the taxpayer’s position that the $1 million lump sum payment shouldn’t be treated as rent under the lease. The Tax Court also rejected the argument that if the amount is treated as rent, under Section 467, the amount should be spread over the term of the lease. The Tax Court noted that under Section 467, a taxpayer cannot use the “constant rental accrual method” because only the IRS is allowed to apply the method in tax-avoidance situations. Further, under the lease and the provisions of Section 467 and the related regulations, the lump sum payment wasn’t prepaid rent to which the proportional rental method would apply.

Regarding the penalty, the Tax Court recognized that a taxpayer can avoid an accuracy-related penalty based on good-faith reliance on the advice of an independent competent professional. The Tax Court found the CPA who prepared the taxpayer’s return to be competent, but noted that the taxpayer didn’t review Schedule E before filing and that the CPA hadn’t gone over the return with the taxpayer before filing. The Tax Court noted that unconditional reliance on a tax return preparer doesn’t solely constitute reasonable reliance in good faith and that a taxpayer must exercise diligence and prudence. Further, taxpayers have a duty to read their returns. Based on the facts, the Tax Court held that the taxpayer’s reliance wasn’t reasonable and in good faith, and it sustained the penalty.

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David Auclair
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