Risk Management

Accounting Alchemy Earns Lessee a Capital Deduction

The tax court sides with a Sheraton partnership company that successfully defends its accounting methodology against an IRS complaint to win a dedu...
Robert WillensNovember 30, 2009

In a case that demonstrated that hotel lease agreements had “economic substance and were not shams designed merely to reduce taxes,” a Sheraton partnership company battled the Internal Revenue Service and won. Heard before the U.S. Tax Court in May, the case involved a partnership that operates the Sheraton Cleveland Airport Hotel in Ohio, which is owned by the City of Cleveland.

At the center of the issue was the sixth “supplement to lease” agreement dated August 11, 1989, which increased the minimum annual rent the partnership was obligated to pay the city under the lease from $195,000 to $300,000. (The percentage of the partnership’s gross receipts rent remained unchanged.) In addition, the case examined a supplement to the lease agreement that entitled the partnership to credits against the percentage rental for certain “eligible improvements.” In any given year, the rent credit was capped at $400,000, but eligible improvements in excess of the limit could be carried forward to later years.

Further, the 1990 “amended lease” increased the maximum amount of rent credit in any given year to $600,000. In cases where the partnership received a credit against rent for the full cost of an eligible improvement in the year in which the improvement was made, it deducted that cost as a rent expense on its federal tax return for that year. The IRS contested this treatment, but the taxpayer prevailed. (See Hopkins Partners v. Commissioner, T.C. Memo. 2009-107.)

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Substitute for Rent

It is well settled that a taxpayer’s deductions for capital expenditures, if allowable at all, come by way of amortization or depreciation. In short, the capital expenditure is deducted only over a sometimes lengthy period of time. Capital expenditures include amounts paid out for new buildings, permanent improvements, and restoration. It was undisputed that, here, the eligible improvements constituted capital expenditures.

WillensFinal“Whether the value of improvements constitutes rent depends on the intention of the parties to the lease.” — Robert Willens

Generally, when a lessee makes and invests in improvements on the property leased, the lessee is entitled to recover that investment through depreciation deductions.1 There is, however, an exception to this rule for cases in which a lessee places improvements on real estate that constitute a substitute for rent. In that event, the tax code, specifically Regulation Sec. 1.61-8(c), states that the cost of the improvement is rental income to the lessor. Moreover, case law provides that when an improvement is in lieu of rent, the amount invested in the improvement is currently deductible by the lessee as a rent expense. (See Your Health Club, Inc. v. Commissioner, 4 T.C. 385 (1944).)

Whether the value of improvements constitutes rent depends on the intention of the parties to the lease. In the Cleveland hotel case, the court found that the express language of the lease agreements clearly indicates that the parties intended that the expenditures for eligible improvements were in lieu of the partnership’s payment of percentage rent. Indeed, the agreement stated that “…the partnership shall be entitled to receive a credit towards the payment of rent in an amount equal to the cost of the eligible improvements….”

In addition, the partnership consistently treated the eligible improvements, both on its books and records and in its tax returns, as a deductible expense in the year in which it obtained a rent credit. Accordingly, based on such factors, the court was able to easily conclude that the parties to the lease agreements intended that the eligible improvements be substitutes for rent.

The other principal argument made by the IRS also fell on deaf ears; that is, the IRS asserted that the partnership’s use of rent credits did not “clearly reflect income” because such use has the effect of converting depreciable property into rent expense. However, the court admonished the IRS, saying that the commissioner cannot require a taxpayer to change from an accounting method that clearly reflects income merely because the commissioner considers an alternate method to more clearly reflect income.

In this case, the accounting method of treating the cost of eligible improvements credited against rent as a rent expense has been accepted by both the courts and the regulations. Since, here, the partnership consistently accounted for its eligible improvements under an “approved” accounting method, the court ruled that the commissioner is “not at liberty” to require the partnership to use a different method of accounting. As a result, and although it is not easy to do, the partnership succeeded in transmogrifying a capital expenditure into a fully deductible expense.

Contributing editor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.

1 See Reg. Sec. 1.162-11(b).