Is paying a C corporation not to make use of property rental income? The question arises in this case in order to determine if such payments potentially constitute personal holding company income under IRC §543 which could end up subjecting the corporation to the personal holding company tax under IRC §541 if it is determined to be a personal holding company pursuant to IRC §542. Field Service Advice 20152102F attempts to answer this question.
If a C corporation is found to be a personal holding company, it will owe a 20% tax on the amount of any undistributed personal holding company income for the year. That tax is in addition to any other taxes owed by the corporation and generally was aimed at “incorporated pocketbooks” where investment assets were being held by a corporation but were not distributed as dividends to avoid the double tax on corporate income—thus the 20% corporate level tax which is meant to remove such an incentive, as it is the same rate as the maximum rate on qualified dividends.
A corporation is treated as a personal holding company under §543 if it meets two tests. First, more than 50% of the corporation’s stock must be held, directly or indirectly, by five or fewer individuals. Second, the corporation must meet an income test that looks to see if 60% of its gross income is personal holding company income as defined in IRC §544.
Rents may or may not be considered personal holding company income based on a test found at IRC §544(a)(2). Rental income is excluded if:
- Adjusted rental income is more than 50% of adjusted ordinary income and
- the sum of--
- the dividends paid during the taxable year (determined under section 562),
- the dividends considered as paid on the last day of the taxable year under section 563(d) (as limited by the second sentence of section 563(b)), and
- the consent dividends for the taxable year (determined under section 565),
equals or exceeds the amount, if any, by which the personal holding company income for the taxable year (computed without regard to rentals and use of corporate property by a shareholder, and computed by including as personal holding company income copyright royalties and the adjusted income from mineral, oil, and gas royalties) exceeds 10 percent of the ordinary gross income.
In this case the corporation held property adjacent to a plant owned by another corporation. That corporation wished to have a “buffer” around the plant to insure it would not face potential liability should something go wrong at the plant (the FSA is redacted to protect the identities of the parties involved, so the exact nature of what could go wrong isn’t made clear).
Thus the plant owner agreed to pay the taxpayer money annually in exchange for agreeing not to develop the adjacent properties and to place restrictions otherwise on the use of property. The agreement (which is referred to as a “negative easement) continued for a specific term of years or until the plant owner terminated the agreement.
The taxpayer was arguing that this was simple business income and was not rental income (presumably if it is rental income this corporation is going to be facing the personal holding company tax). The FSA was issued to help guide the IRS field personal on how to handle this income.
The FSA notes that there’s no authority that the National Office found directly on point regarding the treatment of negative easements for purposes of the personal holding company tax. However it did find that cases involving CRP payments to farmers and their self-employment tax treatment to be instructive.
Determining if an item is for rental of real estate is important in the context of the self-employment tax, as such payments are exempt from self-employment tax even if part of an active trade or business. The memorandum notes that there are a pair of cases in this area—cases that appear contradictory, but which the FSA concludes actually both analyses would come to the same conclusion in this case.
The CRP payments are made to farmers to refrain from farming their property—thus, at first glance appearing identical to what is happening in the case of the plant. However the memo notes that farmers in CRP programs also agree to perform certain ongoing maintenance tasks with regard to the land held out from production.
In the case of Wuebeker v. Commissioner, 205 F.3d 897, (6th Circuit 2000), rev’g 110 TC 31 the Sixth Circuit found such payments were not rental income. Noting that it was a close question and, that for purposes of escaping self-employment tax the rule was to be narrowly construed, the Court found that the requirements to perform significant activities by the farmer and the fact that the government did not actually occupy or directly use the land meant the payments were not rent.
However when the IRS attempted to apply this rule broadly to all farmers, the Eighth Circuit in the case of Morehouse v. Commissioner, 769 F.3d 618 (8th Circuit 2014) rev’g 140 TC 350, found that such payments constituted rental income. In this case the Court found that the government effectively had possession, using the land for its purposes (conservation) and that, at least for nonfarmers, such payments are rents not subject to self-employment tax. The Court specifically rejected the analysis in Wuebeker.
The FSA notes, however, that in this case the taxpayer did not have to perform any services, unlike the taxpayer in Wuebeker. Given the Sixth Circuit found the case to be a very close question and biased in favor of not finding the payment to be rental based on the “narrow construction” test for excluding items from tax, the memo concludes that even under the Wuebeker analysis this payment would be rent for §543 purposes. And, as well, it clearly would be rent when subjected to the Morehouse test.
The memorandum also considers the issue of whether there might be a sale or exchange of an asset that might create a different type of income and concludes that answer is no as well. Citing the Supreme Court’s decision in Commissioner v. Gillette Motor Transport, Inc., 346 US 130 (1960) and Revenue Ruling 70-153, the proper treatment of payments received for temporary easements is as rental income.
Thus, the FSA concludes, the “most supportable” treatment under the tax law is that the payments represent rent and must be considered such when apply the personal service company tests noted above.