Small Business Taxes & Management^TM--Copyright 2010, A/N Group, Inc.

Introduction

Owning real property personally (or through another entity) and leasing it to your business generally makes sense. It makes selling your business easier (the real estate is separate) and the real estate is protected from the business's creditors. It also makes other options, such as bringing in a partner or shareholder to the business, while still retaining control of the property, easier. But what works for real property may not work as well for personal property such as equipment or furniture and fixtures. If you do lease real (or personal) property to your business and want to insure you get the proper tax treatment, you've got to observe the rules.

Noncorporate Lessor Rule

Claiming the Section 179 expense option is generally straightforward, but there are some potential traps and one of them is the leasing of equipment by a noncorporate lessor. That includes an individual, partnership or LLC, and an S corporation. A noncorporate lessor can't take the Sec. 179 deduction unless:

• the term of the lease, taking into account options to renew, is less than 50 percent of the class life of the leased property, and
  
• the lessor's Sec. 162 business expenses for the leased property claimed during the initial 12-month period following the transfer of the property to the lessee exceeds 15 percent of the rental income produced by the property.

You might be able to meet the first test, but the second could be very difficult to pass.

In a Tax Court case (Ross P. Thomann et ux., T.C. Memo. 2010-241) the taxpayers owned and operated a farm and orally agreed to lease 124 acres of their farmland as well as various buildings, grain storage bins and equipment to a farm corporation. The taxpayers never memorialized the lease in writing. Included in the lease were grain bins, a grain dryer, and certain other property. Were it not for the lease, the farm property should normally have qualified as Sec. 179 property since it was special purpose agricultural equipment.

The class life depends on the property or the use of the property. For example, a heavy-duty truck is 6-year property; furniture and fixtures is 10-year. The taxpayers contended that the lease term was one year, which would be less than 50 percent of the class life. The IRS argued that the lease terms were for an indefinite period. The Court found since there was no written lease and the taxpayers presented no evidence regarding the terms of the lease the term was indefinite. Thus, the property failed the first test.

Whether the property would have passed the second, business expense test, became a nonissue. But, there's a good chance it wouldn't pass that test either. The rule requires the Sec. 162 business expenses to exceed 15 percent of the rental income. Those expenses don't include any rent or reimbursed expenses nor does it include taxes, interest, or depreciation. Maintenance, insurance, and similar expenses would qualify, but they may not add up to enough to pass the hurdle.

Recordkeeping

The first mistake was not to have a written lease. If you don't have written documentation, you're in trouble right from the start. You may not get as far as to argue with the agent whether or not an item is deductible. Written documentation such as a lease often even more important when the transaction is between family members or between a shareholder and the corporation.

In this case the taxpayer also tried to claim the Section 179 expense on office expenditures. The taxpayer claimed purchases of office materials to remodel the taxpayers' office, and the office materials included office furniture and fixtures. You can't claim the expense option on structural components of a building such as plumbing and lighting fixtures. Here the Court could not determine whether the office materials qualified. The taxpayers failed to present any evidence showing what office materials were expensed on their return. The Court denied them a deduction for these expenditures.

Make sure you can identify every item of property you're taking the Sec. 179 election on. That could include a bill of sale, title, etc. Make sure that you can trace the actual item. If you only have a few vehicles purchased over a period of time, you may only have to list "2010 GMC Sierra pickup". But if you bought four miter saws--one 10" compound, one 12" compound sliding, and two 12" compound saws but two different models and are only claiming the expense option on 3 of them, how would you trace them? That becomes even more important if one or more of the items are retired, sold, or transferred to personal use or if part of the Sec. 179 amount for the year must be carried over because of an income limitation.

--Last Update 11/18/10