In Sinopoli v. Commissioner,[1] the taxpayers sought to leverage IRC 280A(g), a provision allowing individuals to rent out their personal residences for up to 14 days annually without declaring the income. The taxpayer's S corporation reported over $290,000 in rental expenses over a three-year span, purportedly for renting the shareholders' homes for monthly meetings. However, the Tax Court significantly curtailed the allowable deduction.

The “Master’s” Rule

IRC §280A(g) includes what is commonly termed the “Master’s” rule, which permits a taxpayer to omit from their income any sums obtained from leasing their home, provided it’s rented for no more than 14 days annually. The moniker “Master’s” alludes to the frequent utilization of this unique provision by residents of Augusta, Georgia, during the annual Master’s Golf Tournament, but the provision is also used around other major sporting events such as the Super Bowl.

IRC §280A(g) provides:

(g) Special rule for certain rental use. Notwithstanding any other provision of this section or section 183, if a dwelling unit is used during the taxable year by the taxpayer as a residence and such dwelling unit is actually rented for less than 15 days during the taxable year, then—

(1) no deduction otherwise allowable under this chapter because of the rental use of such dwelling unit shall be allowed, and

(2) the income derived from such use for the taxable year shall not be included in the gross income of such taxpayer under section 61.

Facts of this Case

In this situation, the taxpayers aimed to combine the Master’s rule with the rental of their homes to their S corporation. The strategy was for the S corporation to deduct the amounts paid to the shareholders as rent. Then, these payments would not be taxable on the shareholders’ individual returns. Such tactics are frequently circulated on social media, often advocating for the declaration of exorbitant rental amounts. In this instance, the shareholders fully embraced this aggressive approach.

The opinion describes their arrangement as follows:

Before 2015 petitioners met occasionally at a hospital where they worked or at Planet’s fitness center in Gretna, Louisiana, to discuss Planet’s business. Because of the distance and petitioners’ work schedules, it was difficult for them to schedule meetings where all three petitioners could attend. Often one petitioner was absent from these meetings because of scheduling problems. Beginning in 2015 petitioners arrived at a plan to have Planet pay them rent for the use of their homes for business meetings in their personal residences. When meetings were actually held, they were generally the only attendees but occasionally one of the wives attended. Other family members were home during some meetings. Petitioners failed to produce any credible evidence of what business was conducted at such meetings, and their testimony was vague and unconvincing regarding the meetings.

Planet paid rent to petitioners for the use of their residences. Petitioners did not obtain an appraisal of the rental value of their residences as meeting space. Dr. Sinopoli researched rental rates for meeting spaces where petitioners lived and determined that meeting spaces rented at a rate of $1.83 per square foot, which petitioners used to calculate rent for the residences’ common areas. Initially, the monthly rent to each petitioner (based on the size of the common space) was different. Sometime in 2016 through September 2017 Planet began paying $3,000 in monthly rent to each petitioner. …

For each year at issue Dr. Sinopoli and Dr. Siragusa reported the rent as income on Schedule E of their personal returns and excluded it from their gross income pursuant to section 280A(g), which provides that rental income from the rental of a taxpayer’s residence is not included in gross income if the residence is rented for no more than 14 days in a taxable year. Mr. Hurring reported the rent for 2015 and 2017 and excluded it from gross income. He did not report it for 2016.[2]

However, the IRS agent raised eyebrows at the perceived reasonableness of the S corporation shelling out over $290,000 to conduct 36 monthly meetings, especially when primarily involving just a handful of participants. He decided to look elsewhere for his comparable meeting room expenses.

Revenue Agent (RA) Jacob Burgess was assigned to examine Planet’s S corporation returns and petitioners’ personal returns for the years at issue. He researched the local rental rate for meeting space and determined that locally available meeting space accommodating 500 to 1,200 people rented for approximately $500 for a full or half day. He sustained a $500 rent expense for each meeting that they substantiated with notes of an actual meeting. They did not provide any meeting notes for 2015 but substantiated 12 meetings at Dr. Sinopoli’s residence during 2016 and 9 meetings at Mr. Hurring’s residence during 2017. Accordingly, respondent disallowed the rent deduction for 2015 in its entirety and allowed rent expense deductions of $6,000 and $4,500 for 2016 and 2017, respectively.[3]

The Tax Court’s Decision

The Court started by emphasizing that for this deduction to be valid, it must satisfy the “ordinary and necessary” criteria for business expenses as stipulated in IRC §162(a).

Section 162(a) allows a deduction for ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business. Whether an expense is ordinary and necessary is a question of fact. Commissioner v. Heininger, 320 U.S. 467, 475 (1943). An expense is ordinary if it is usual or customary in the taxpayer's trade or business. Deputy v. du Pont, 308 U.S. 488, 495 (1940). An expense is necessary if it is appropriate or helpful in carrying on the trade or business. Heineman v. Commissioner, 82 T.C. 538, 543 (1984). Even if an expense is ordinary and necessary, the expense is deductible only to the extent that it is reasonable in amount. Audano v. United States, 428 F.2d 251, 256-57 (5th Cir. 1970); Ciaravella v. Commissioner, T.C. Memo. 1998-31. The requirement of reasonableness is inherent in the phrase “ordinary and necessary” in section 162. Fuhrman v. Commissioner, T.C. Memo. 2011-236, slip op. at 6. The reasonableness concept has particular significance in dealings between related parties. Id.[4]

The opinion highlighted the IRS’s reservations regarding the deductions claimed over the three-year period.

Respondent argues that petitioners have substantiated only 12 and 9 meetings that occurred during 2016 and 2017, respectively, and no meetings for 2015. He further argues that the amount of rent paid for each meeting, between $3,000 and $4,000, was not reasonable.[5]

The Court first examined the evidence to determine whether the claimed meetings actually took place. Upon review, it was established that only a portion of these meetings could be verified as having occurred.

Petitioners have not presented any written documentation such as minutes, agendas, or calendars showing that all the claimed meetings occurred during the years at issue to substantiate rent deductions of Planet. Furthermore, we find that petitioners’ testimony was not credible as to the frequency of meetings during the years at issue. Their testimony was inconsistent and included testimony that petitioners did not recall the number of meetings that took place. Planet deducted rent expenses for three meetings per month, once at each residence. Petitioners have not established that meetings occurred at that frequency. They have established only one meeting per month for January 2016 through September 2017. Respondent has allowed in the notices of deficiency a $500 rent deduction for each meeting. Petitioners have also established with their testimony that some meetings occurred during 2015. Accordingly, we will allow a deduction of rent for 12 meetings for 2015.[6]

The Court’s analysis on the reasonableness of the rent was critical for this case. Under IRC §162(a), the ordinary and necessary standard means that a business expense must be both “ordinary” (common and accepted in the taxpayer’s line of business) and “necessary” (appropriate and helpful for the business).

The amount of over $290,000 as rent for the shareholders’ residences for these meetings was significantly high. Especially when considering the nature of these meetings – primarily held between a limited number of individuals and with a frequency of only once a month.

Comparing the claimed rent amount with the fair rental value for similar properties in the area, the Court agreed with the IRS agent’s estimation that a sum of $500 per meeting was a more reasonable rate for the rental value of the homes for business purposes.

Petitioners have not established the reasonableness of the rent with documentation or credible testimony. Planet deducted $290,900 in rent that it purportedly paid to petitioners over less than three years. We agree with respondent that it seems that petitioners adopted a tax savings scheme to distribute Planet’s earnings to petitioners through purported rent payments, claim rent deductions, and exclude the rent from their gross income relying on section 280A(g). While petitioners argue that the $500 rent determined by RA Burgess was not reasonable, we disagree and find to the contrary that $500 allowed per month is actually generous. Obviously, only small portions of the residences were used for the meetings when they occurred. We hold that Planet is entitled to deduct $6,000 for 2015 (12 meetings × $500) and has previously been allowed an expense deduction for rent of $500 per month for each month from January 2016 through September 2017.[7]

The Key Lesson

This case case underlines a crucial principle: while the Internal Revenue Code (IRC) provides various provisions for deductions and exclusions, those provisions don’t operate in isolation. They often interrelate and are subject to overarching principles of taxation.

In this instance, while IRC §280A(g) allows for exclusion of rental income under specific conditions, it does not automatically grant a blank check to charge any rental rate the taxpayer wishes without regard for reasonableness. IRC §162 imposes its own set of requirements on business expenses, including the fundamental principles of “ordinary and necessary” and reasonableness.

What exacerbated the situation for the taxpayers in this case was the related-party nature of the transaction. When the same individuals have control over both the entity paying the rent and the entity receiving the rent, there’s an inherent potential for abuse. Such transactions are often viewed with skepticism by the IRS and the courts, as they can be manipulated to siphon off corporate profits or to create deductions where they wouldn’t normally exist.

[1] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/most-of-s-corporation%27s-rent-and-advertising-expenses-disallowed/7h2tb (retrieved August 15, 2023)

[2] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023

[3] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023

[4] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023

[5] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023

[6] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023

[7] Sinopoli v. Commissioner, TC Memo 2023-105, August 14, 2023