Tax Court Reduces Deductions for Purported Rent Payments to S Corp's Owners

(Parker Tax Publishing September 2023)

The Tax Court held that an S corporation's purported rent payments to its owners for the use of the owners' homes for business meetings were not reasonable in amount and that the owners failed to substantiate the frequency of the meetings, and therefore the court reduced the amount of the allowable deductions. The court found that the owners failed to establish the reasonableness of the rent payments or substantiate that owners' meetings occurred at the frequency claimed by the owners. Sinopoli v. Comm'r, T.C. Memo. 2023-105.

Background

In 2011, Dr. Gary Sinopoli, Dr. Robert Siragusa, and Michael Hurring formed an S corporation, Planet LA, LLC (Planet). Planet was a franchisee of Planet Fitness, a national chain of fitness centers, and owned multiple fitness centers in Louisiana.

Before 2015, Dr. Sinopoli, Dr. Siragusa, and Hurring (i.e. the owners) 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 the owners' work schedules, it was difficult for the owners to schedule meetings where all three could attend. Often one owner was absent from these meetings because of scheduling problems.

Beginning in 2015 the owners 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 their wives attended. Other family members were home during some meetings. Planet paid rent to the owners for the use of their residences. The owners did not obtain an appraisal of the rental value of their residences as meeting space. Dr. Sinopoli researched rental rates for meeting spaces where the owners lived and determined that meeting spaces rented at a rate of $1.83 per square foot, which the owners used to calculate rent for the residences' common areas. Initially, the monthly rent to each owner (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 owner.

Dr. Sinopoli and Dr. Siragusa reported the rent as income on Schedule E of their personal returns and excluded it from their gross income under Code Sec. 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 tax year. Hurring reported the rent for 2015 and 2017 and excluded it from gross income. He did not report it for 2016.

The IRS examined Planet's S corporation returns and the owners' personal returns. It determined that locally-available meeting space accommodating 500 to 1,200 people rented for approximately $500 for a full or half day. Thus, the IRS sustained a $500 rent expense for each meeting that the owners substantiated with notes of an actual meeting. The owners did not provide any meeting notes for 2015, but substantiated 12 meetings at Dr. Sinopoli's residence during 2016 and 9 meetings at Hurring's residence during 2017. Accordingly, the IRS 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.

Planet engaged in national and local advertising as required by its franchise agreement. It paid for national advertising through a system in which the franchisor retained part of the membership fees that it collected for Planet's fitness centers, paid over part of the collected fees to Planet, and retained part for various franchisee charges including national advertising fees.

For local advertising, Planet's owners primarily engaged the services of companies that they met at Planet Fitness's annual franchise conferences. Local advertising included print and email marketing, corporate events, and radio and TV commercials. The owners decided to increase Planet's advertising to attract more gym members and to develop Planet's business with the idea of a potential sale of the business after learning that private equity groups were interested in purchasing franchises.

When Planet started its business, it paid local advertising expenses directly to the local advertisers. In November 2014 Planet changed this practice. Each owner organized a C corporation (marketing companies). The owners instructed Planet's local advertisers to bill the marketing companies, and Planet began to pay fees to the marketing companies (marketing fees). The marketing fees were the marketing companies' only source of income. The marketing companies did not perform marketing or other services for other businesses. They did not report any wage expenses on their corporate returns. After examining the marketing companies' corporate returns, the IRS determined that the marketing fees exceeded the amounts that the marketing companies paid to the local advertisers. The IRS determined that Planet substantiated the business purpose of part of the marketing fees equal to the amount that the marketing companies paid to local advertisers and disallowed its reported expenses for the remainder of the marketing fees (excess marketing fees).

The owners petitioned the Tax Court to redetermine the deficiencies resulting from the disallowance of the rent and advertising expense deductions. The Tax Court consolidated their cases.

Analysis

The Tax Court agreed with the IRS that the owners substantiated only 12 and 9 meetings that occurred during 2016 and 2017, respectively, and no meetings for 2015. The court also found that the amount of rent paid for each meeting, between $3,000 and $4,000, was not reasonable. The court noted that under Code Sec. 162(a), a business expense that is ordinary and necessary is deductible only to the extent that it is reasonable in amount. The court explained that the concept of reasonableness is inherent in the phrase "ordinary and necessary" and added that reasonableness has particular significance in dealings between related parties.

The court found that the owners did not present 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, the court found that the owners' testimony was inconsistent and included testimony that the owners did not remember how many meetings took place. In the court's view, the owners failed to establish that the meetings occurred at the frequency of three per month (one at each residence). Rather, the court determined that they established only one meeting per month for January 2016 through September 2017. The court noted that the IRS allowed in the notices of deficiency a $500 rent deduction for each meeting. The court also found that the owners established with their testimony that some meetings occurred during 2015, and therefore the court allowed a deduction of rent for 12 meetings for that year.

The court also found that the owners failed to establish the reasonableness of the rent with documentation or credible testimony. The court noted that Planet deducted $290,900 in rent that it purportedly paid to the owners over less than three years. The court agreed with the IRS that it seemed that the owners adopted a tax savings scheme to distribute Planet's earnings to the owners through purported rent payments, claim rent deductions, and exclude the rent from their gross income relying on Code Sec. 280A(g). In the court's view, the $500 rent allowed by the IRS was generous considering that only small portions of the owners' residences were used for the meetings when they occurred. The court concluded that Planet was entitled to deduct $6,000 for 2015 (12 meetings x $500), and was previously allowed an expense deduction for rent of $500 per month for each month from January 2016 through September 2017.

The court also agreed with the IRS that the marketing fees, like the purported rent payments, were a means to distribute earnings from Planet to the owners. The court said that there was a total lack of evidence to support the excess marketing fees. Nor did the owners substantiate, in the court's view, the business purpose of the excess marketing fees. Therefore, the court held that Planet was not entitled to treat them as business expenses.

For a discussion of the general rules for deducting rent, see Parker Tax ¶92.501. For a discussion of the exclusion for certain income from the rental of a dwelling used as a personal residence under Code Sec. 280A(g), see Parker Tax ¶86,110.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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