Ninth Circuit Court of Appeals Affirms IRS Position Disallowing Deductions for Rental of Real Estate to Corporation
One fairly common technique for owners of closely held businesses to extract additional tax-advantaged income from their companies has been for them lease real estate or personal property to their businesses. This kind of rental permits the owners to withdraw money from the business without it being classified as salary or dividends. However, if closely held business owners use the rental income to offset real estate passive activity losses, they could expose themselves to possible disallowance under the IRS's self-rental rule.
In the Beacher case, the Ninth Circuit Court of Appeals (based in California) recently ruled that a closely held business owner renting real estate to their business won't result in a tax break. The court ruled that the rental income cannot be offset by passive losses even if those losses come from real estate activities. The court affirmed IRS rules that deny passive losses against rental income when the taxpayer works more than 500 hours in one year for the business, and greater than 50% of the business's stock is held by five or fewer stockholders. Although this rule applies to C corporations there is a similarly restrictive rule for rentals to S corporations.
Business owners can still obtain some tax benefit from renting to their businesses. Payroll taxes are not owed on these kinds of rental payments, unlike salary payments. But, if the rental amount is deemed not to be arm's length (i.e., it is excessive), the IRS could try to reclassify that excess amount as additional salary or possibly even as a nondeductible dividend.
