United States

One-time payment under lease constitutes rental income in year of receipt


In a recent decision, Michael H. Stough et ux. v. Commissioner, 144 T.C. No. 16, No. 8256-11, the U.S. Tax Court sided with the IRS in ruling that a $1 million lump-sum payment was taxable in the year received and by dismissing a reasonable-cause argument advanced by Stough in sustaining an accuracy-related penalty. In arriving at this conclusion, the court first held that the payment constituted rental income in the hands of the recipient. The court went on to decide the rental income was reportable in the year of receipt because the lease did not specifically allocate a dollar amount of rent, and further, that the constant rental accrual and proportional rental accrual methods were not applicable to the lease.


Not unlike other sources of income, rental income is broadly defined under section 61 and the regulations thereunder. Section 467, which deals with rental accruals, was enacted to curb perceived abuses relating to mismatched reporting of rental income and expenses by lessors and lessees. Section 467(d)(2) provides that the section 467 accrual rules apply only to leases meeting both of the following criteria:

  1. Increasing/decreasing rents (often referred to as "stepped rents") or deferred/prepaid rents
  2. Aggregate rental payments exceeding $250,000

Under section 467(b)(1), rents generally accrue in accordance with the lease terms and any rent to be paid after the close of the reporting period is allocated to the proper reporting period based on present value concepts. The constant rental accrual method under section 467(b)(2), where applicable, provides an exception to this general rule. Reg. section 1.467-3(a) specifies that the constant rental accrual rules only apply in situations where the IRS has made a tax avoidance determination. Further, a concept known as proportional rental accrual may apply if a section 467 lease does not provide for adequate interest on prepaid or deferred rent.

Case analysis

Stough's wholly-owned development company agreed to develop and then lease a property to an unrelated company. In return, Stough's company would receive rent payments based on a formula driven by costs incurred in developing the property. The lessee had the option to make a lump-sum payment in order to reduce future monthly rent payments. The lessee made a $1 million-one-time payment in 2008 and included the full amount on a Form 1099-MISC issued to Stough's company. Both Stough and the lessee reflected the payment as rent on their 2008 tax filings. Stough also claimed an offsetting $1 million deduction for "contribution to construct" expense.

After receiving a notice of deficiency disallowing the $1 million contribution to construct expense, Stough pursued a new argument. Stough conceded the disallowance of the deduction, and then argued that the $1 million payment received was incorrectly reported as rental income. Stough also requested an updated Form 1099 from the issuer in an apparent attempt to substantiate this new position. Further, Stough argued that if the payment was classified as rental income, it should be allocated ratably over the life of the lease under the section 467 rules.

The tax court determined that the lump-sum payment constituted rent under Reg. section 1.61-8(c) regardless of the intent of the parties. The court did acknowledge that under certain circumstances a lessee's funding of leasehold improvements will not necessarily result in rental income for the lessor. The court noted that the payments in question in Stough were not for leasehold improvements. Thus, a possible exception related to leasehold improvements would not apply and the payment would be treated as rental income.

The court then considered Stough's alternative argument that the rental income should be recognized over the life of the 10-year lease under section 467 in lieu of being recognized in the year of receipt. Aside from possible exceptions under section 467, rents are generally recognized for tax purposes no later than the tax year of receipt. The court agreed with both parties in concluding that the lease did in fact fall under the guise of section 467. The court referenced Reg. section 1.467-1(c), which provides rules for allocating rents for leases that provide a specific dollar allocation schedule and for those that do not. Stough's lease agreement did not contain a schedule allocating specific rent, and as a result, the court found that the entire $1 million payment must be included as rental income in 2008.

Additionally, the court found that neither the constant rental accrual nor proportional rental accrual provisions under section 467 were applicable to the lease. Constant rental accrual did not apply since the IRS had not made a tax avoidance assertion, and proportional rental accrual was rendered moot when the court determined that there was no prepaid or deferred rent under the lease.

Finally, the court upheld an accuracy-related penalty after dismissing the reasonable cause argument presented by Stough.


The Stough case illustrates the complexities contained in the section 467 rules and highlights the importance of careful drafting of lease documents. Had the lease specifically allocated the lump-sum dollar amount to specific periods, Stough may have succeeded in arguing that only a portion of the payment was reportable in 2008 and the remainder in subsequent tax years.

It is important to note that the mere fact that both parties' report an item in the same manner does not override the application of the section 467 rules.


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