Recently, two Circuit Courts shot down the taxpayers in two cases involving rents and S Corporations.
In the Estate of Stuller, the Seventh Circuit Court of Appeals addressed a Tennessee Walking Horse breeding operation held in an S Corporation. Surprise! The IRS, the District Court, and the Seventh Circuit found that the breeding operation was a hobby. Among other facts not in the favor of the taxpayer was that the operation lost money for 15 of 16 years. It made a whopping $1,500 profit one year. The breeding activity was not conducted in a business-like manner. No real surprise, so far.
The Stullers’ S Corporation rented property from Mr. and Mrs. Stuller, the rents from which apparently they reported as income. After the Stullers were found by the courts to have a non-deductible hobby in the S Corporation, they sought for the courts to hold that they did not have to report as income the rental payments that they received from the hobby-bearing S Corporation. They were rebuffed. The S corporation is separate from the owners. They organized the arrangement and it did not turn out like they wanted. Tough luck. They picked their poison.
In Williams v. Commissioner, the Fifth Circuit addressed a case where an S corporation rented realty to a C corporation. The Williamses owned all of the stock in both companies. Mr. Williams materially participated in the business of the C corporation. The arrangement appeared to be arms’- length and there is no indication that the IRS had a problem with the economics of the deal. The Williamses reported the rental income in the S corporation as passive income, which, conveniently, was offset by losses in other passive activities.
The Williamses got it all wrong. While the “self-rental rule” is a bit obscure, it is aimed squarely at what the Williamses were doing. The IRS, the Tax Court and the Fifth Circuit all agreed that under the self-rental rule, they had to classify the rent income as nonpassive income and their passive losses could not offset the related-party rental income.
In both cases, it appears that the taxpayers tried to be a little bit too clever in structuring their activities for tax purposes. In both cases, they got bad results.