The IRS is often suspicious when related parties, such as the sole shareholder of a corporation and the business entity, enter into a favorable tax arrangement. To be on the safe side, you must observe all the legalities. This is evidenced by a new case, Ng, TC Memo 2018-14, 2/5/18, where a physician’s corporation tried to deduct rent payments it purportedly made for space in his personal residence.
Generally, a corporation may deduct its “ordinary and necessary” business expenses, which may include rent payments. But rental payments for a taxpayer’s home office are deductible only if there is evidence of a bona fide arrangement and other tax law requirements are met.
In this recent case, a physician was the sole owner of an incorporated medical practice in California. During 2012 and 2013, the physician was covered by a contract with the Emergency Department Physicians Medical Group and was assigned to work at Good Samaritan Hospital in Los Angeles as a “Physician Independent Contractor.”
The physician worked out of the personal residence in Los Angeles that he has owned since 1997. The second story of the residence is used solely for his medical practice. It has a separate external entrance with alarm panel access, measures 968 square feet and consists of a converted master bedroom, a den, a lavatory and a furnace area.
The space was used to perform administrative tasks for the practice, such as remotely accessing Good Samaritan’s electronic medical records to complete physician notes on patients the physician treated at the hospital, in addition to continuing education training and medical board certification activities. The physician does not see, and never has seen, patients in any part of the residence.
The only individuals besides the physician who use or have been in the space are his paid assistant (who accesses the space only via the external stairs) and malpractice defense attorneys who have met with him from time to time.
For the two tax years in question, 2012 and 2013, the firm deducted the mortgage interest payments for the residence — about $30,000 a year — it had designated as “rent.” The physician claims that the second story of the residence was used for business purposes like performing administrative tasks for the corporation and for continuing education training and medical board certification activities.
The Tax Court noted that the close relationship between a lessor and lessee does not mean that a valid lease agreement between them cannot exist. However, this requires a careful examination of the circumstances to determine whether the payments are, in fact, for the rental of the property.
Unfortunately, the physician did not produce any evidence of a written rental agreement or other documentation to support his position that the amounts claimed were actually rent. He did not treat the arrangement as a bona fide rental arrangement nor did he report any rental income on his returns. Accordingly, the deductions were denied.
If you have clients a similar situation, make sure the appropriate parties enter into a formal rental agreement. Furthermore, income from the rental activity must be reported — you can’t have your cake and eat it, too.
About Ken Berry
Ken Berry, Esq., is a nationally known writer and editor specializing in tax, financial, and legal matters. During his long career, he has served as managing editor of a publisher of content-based marketing tools and vice president of an online continuing education company. As a freelance writer, Ken has authored thousands of articles for a wide variety of newsletters, magazines, and other periodicals.