Taxing Lessons Case Summaries

Case — Income Reclassification

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TL Case Summ

THE QUESTION

After years of filing tax returns as a sole proprietorship, can a bar owner re-characterize the income as rental?

THE DISPUTE

Taxpayer Says: Because there was no involvement in the management of the bar, the income is properly considered rental.

Internal Revenue Service Says: The original position on filed tax returns is admission of ownership, and sole proprietorship is the proper classification.

THE LAW

From Commissioner v. Culbertson, 337 U.S. 733, 742 (1949): The parties’ own intent is foremost in the Court’s consideration.

From Knight v. Commissioner, 115 T.C. 506, 513 (2000): State law determines the nature of property rights, and Federal law determines the appropriate tax treatment of those rights.

From Md. Code Ann., Real Prop. sec. 1-101(h) (LexisNexis 2003): Maryland law defines a lease as “any oral or written agreement, express or implied, creating a landlord and tenant relationship, including any ‘sublease’ and any further sublease.”

THE CAUSE OF THE DISPUTE

When gathering records in response to an IRS audit, the taxpayer’s accountant realized the taxpayer, though he owned the business building, had no real involvement in the daily operations. Instead, he had an oral lease with his friend for the building rental, and was simply a landlord. The income was reclassified to reflect this treatment.

The IRS says the taxpayer’s name was stated as the bar’s owner on the liquor license and lottery paperwork, the taxpayer was the only person originally named on the bar’s only bank account, and the taxpayer submitted the bar’s gross income and losses to the IRS on his personal tax return. The taxpayer changed position only after the audit began, so the IRS believes the change was made because of the expected tax consequences of the audit, and should not be allowed.

According to prior tax court cases, the decision about who is carrying on a trade or business can be based on three factors: Ownership of the assets, who provided the labor, and how the business was held out to the general public.

In this case, the taxpayer owned the building, and his friend, for whom the bar was named, took care of day to day operations.

WHAT WOULD YOU DECIDE?

Make your selection, then see “The Court’s Decision” below for a full explanation

For the or for the

THE COURT’S DECISION

Download (PDF, 20KB)

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HL Carpenter, an experienced investor and a CPA, specializes in reader friendly articles on taxes and investing for individuals and small businesses, and publishes two newsletters: Taxing Lessons and Top Drawer Ink. Visit TaxingLessons.com and HLCarpenter.com.

This information should not be considered legal, investment or tax advice. Taxing Lessons and Top Drawer Ink Corp. do not provide legal, investment or tax advice. Always consult your legal, investment and/or tax advisor regarding your personal situation.

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Right answer!
Sorry, wrong answer :(
For the Taxpayer. The oral lease reflected financial reality. Taxpayer was a landlord.
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