Leasehold Improvements & Substitute For Rent

The IRS really went after Hopkins Partners in this case. The Tax Court rejects not one, not two, not three, but all seven of the IRS's arguments.

Hopkins leased a Sheraton Hotel from the City of Cleveland located at the airport. The City wanted Hopkins to make substantial improvements to the Sheraton otherwise the City was going to build a second hotel. The Sheraton was losing money and Hopkins could not obtain a commercial loan. Hopkins renegotiated the lease with the City and secured rent credits in exchange for eligible improvements. Excess rent credits were carried forward to subsequent years.

Hopkins deducted the eligible improvements against rent expense in the year rent credits were received. Once rent credits were received, Hopkins transferred title of the improvement to the City. When eligible improvements generated excess rent credits, Hopkins capitalized and depreciated the improvements. In subsequent years when the excess rent credits were used, Hopkins transferred title to the City, recognized a sale on the transfer, and calculated gain on the transfer including depreciation recapture.

The IRS argued:

1. the improvements were not substitutes for rent, 
2. the rent credits should be limited
   
3. the transfer of title was illusory,
   
4. the rent credit arrangement lacked economic substances,
   
5. use of the rent credit did not clearly reflect income,
   
6. use of the rent credit was an accounting method change, and finally
   
7. accounting method changes require adjustments under section 481(a).

A common theme throughout was the IRS's focus on the City's tax exempt status. Since the City pays no tax on rent received from Hopkins tax revenue is lost, and at the same time tax deductions are given. The Court considers this point. In the end, however, the lease controlled the transaction. More importantly, there were too many non-tax reasons for the rent credit arrangement. This favored Hopkins's position. Hopkins also kept very good records, obtained opinions from two accounting firms, and treated the transactions consistently throughout the entire period.

There is the potential for abuse when one party to a transaction is tax indifferent, as is the case here with the City. I think another common example is where a Not-for-profit has a for-profit subsidiary. Frequently, the transactions between the not-for-profit and the for-profit allow for deductions on one side and tax-exempt revenue on the other. Lease payments are a prime example. Hopefully the new Form 990 will disclose more of these transactions.

Download HOPKINSPARTNERS.TCM.WPD