IRS and leasehold improvements

I am planning to take advantage of rising vacancy rates in my area to lease a larger office space.

by Charles Blair, DDS and John McGill, MBA, CPA, JD

I am planning to take advantage of rising vacancy rates in my area to lease a larger office space. To receive the best lease rates and terms, I plan to enter into a 20-year lease. The landlord has promised me a total of $80,000 in tenant- improvement allowances to help offset the build-out costs. My accountant told me that this amount must be reported by me as income. How can this be if I am simply investing this money in leasehold improvements that will belong to the landlord at the end of the lease term?

The IRS recently issued final rules under Section 110 of the tax law under which such tenant- improvement allowances would qualify as tax-free payments. Both you and your landlord will be required to report this transaction for federal income tax purposes.

The rule states that tenants are allowed to exclude from their income amounts received for tenant improvements or other construction allowances actually used to construct leasehold improvements that will revert to the landlord at the end of the lease, provided that it is a term of 15 years or less.

If you follow through with your plans to sign a 20-year lease, the amounts received would not qualify for tax-free treatment. We recommend that you reduce the lease term to 15 years and negotiate a five-year option to renew in order to qualify for tax-free treatment.

I run a large group practice with several associates. Because of the employment arrangements that I have negotiated with them and the type and range of management that I use, I have been increasing profits each year, even though I am providing fewer hours of clinical services.

Each year, I have been able to reduce my C corporation's profits to zero through retirement plan contributions and bonuses paid to me. Now, my accountant says that this approach may no longer work. I do not understand why. Can you help?

In a recent case, Pediatric Surgical Associates, P.C. vs. Commissioner, TC Memo 2001-081, the tax court disallowed deductions for bonuses to shareholder-employees of a medical professional corporation that had 20 employees, including two surgeons who were not shareholders. The court said that the issue was not whether the amounts paid were reasonable to the shareholder-employees, but whether they were actually received for services rendered. In this case, the court disallowed the bonuses paid from corporate profit to the extent that it found the profit was attributable to the services of nonshareholder-employees.

Applying the result of this case to your situation could lead to a similar result. While part of the extra profits are related to your management skills, part of it is related to the clinical income generated by your associates. Therefore, part of the bonus deductions to you could be at risk in the event of an audit.

To avoid this situation, we recommend that you plan to elect Subchapter S status for your corporation, effective January 1 of next year. By doing this, you should be able to thwart any IRS attack, since all corporate profits will show up on your personal return at year end, even if you do not remove it as a bonus. Accordingly, converting to a Subchapter S status will eliminate the potential double taxation that could result in the event you are audited and the IRS was successful in its claim that the bonuses paid to you are really dividends rather than reasonable compensation.

You should set up a meeting with your tax advisor immediately to discuss the specific facts of your situation and the tax planning required to make an effective Subchapter S election without any adverse tax consequences.

The information provided in this column is based upon the current Internal Revenue Code, regulations, IRS rulings, and court cases as of the date of this publication. This column is not to be construed as legal or tax advice with respect to any particular situation.

Contact your tax attorney or other advisor before undertaking any tax-related transaction.

Dr. Blair is a nationally known consultant and lecturer, and is a member of the American Academy of Dental Practice Administration. McGill is a tax attorney and MBA. They are the editors of the Blair/McGill Advisory, a monthly newsletter helping dentists to maximize profitability, slash taxes, and protect assets. The newsletter ($177 a year) and consulting information are available from Blair/McGill and Company, 2810 Coliseum Centre Drive, Suite 360, Charlotte, NC 28217 or call (704) 424-9780.

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