Tax Court sustains IRS penalty for treatment of lump sum payment

Tax Hot TopicsTax Hot Topics
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.

David Auclair
+1 202 521 1515

Tax professional standards statement
This content supports Grant Thornton LLP’s marketing of professional services and is not written tax advice directed at the particular facts and circumstances of any person. If you are interested in the topics presented herein, we encourage you to contact us or an independent tax professional to discuss their potential application to your particular situation. Nothing herein shall be construed as imposing a limitation on any person from disclosing the tax treatment or tax structure of any matter addressed herein. To the extent this content may be considered to contain written tax advice, any written advice contained in, forwarded with or attached to this content is not intended by Grant Thornton LLP to be used, and cannot be used, by any person for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code.

The information contained herein is general in nature and is based on authorities that are subject to change. It is not, and should not be construed as, accounting, legal or tax advice provided by Grant Thornton LLP to the reader. This material may not be applicable to, or suitable for, the reader’s specific circumstances or needs and may require consideration of tax and nontax factors not described herein. Contact Grant Thornton LLP or other tax professionals prior to taking any action based upon this information. Changes in tax laws or other factors could affect, on a prospective or retroactive basis, the information contained herein; Grant Thornton LLP assumes no obligation to inform the reader of any such changes. All references to “Section,” “Sec.,” or “§” refer to the Internal Revenue Code of 1986, as amended.