Business owners who own the real estate from which their business operates often structure the real estate in a separate entity, such as a limited liability company (LLC).
This allows them to manage legal risks and avoid any pitfalls associated with future separations of the real estate entity from the business, and in turn, the business pays rent.
While some business owners may view the rent payments as a way to get earnings out of the business (particularly with a C corporation), excessive rent payments can expose the owners to additional tax risk.
As strategic as some business owners might think this is, manufacturing companies may end up paying more in taxes.
Some business owners might pay more in rent when business income is up and less when business income is down. The IRS could see this as income stripping.
Such strategies may subject business owners to additional tax penalties and interest.
How does this apply to manufacturing companies?
Excessive rents may result in paying excess tax because of potential loss of the Domestic Production Activities Deduction (DPAD). This deduction is 9% of income that’s generated from US manufacturing activities.
And, for businesses that allocate income to lower tax states and outside US borders, additional profits taxed in a higher tax home state will result in additional state taxes.
Here’s an example.
The owners of Cogswell Cogs owns the real estate out of which the business operates. In 2015, Cogswell Cogs (an S corporation) generated taxable income of $1 million before the DPAD, after paying $750,000 in rent to Cogs Real Estate LLC.
Based on the $1 million of income, the DPAD is $90,000 and the owner’s taxable income is $1.66 million. He pays $664,000 in taxes based on a 40% tax rate.
If the reasonable amount of rent was $250,000, the DPAD would be $135,000. The owner would save over $18,000 in tax.
What’s reasonable rent according to the IRS?
Reasonable rent is the amount of rent that would be paid on a similar property to an unrelated third party. To determine what amount of rent is reasonable, you’ll need to review comparisons of similar properties.
A real estate professional can help you select and review properties.
How can I protect myself in the event of an IRS audit?
In addition to determining reasonable rent, document lease arrangements between related parties through the execution of lease documents.
If audited, IRS agents would likely review lease arrangements in their totality to define the reasonableness of rent. Taking this extra step can help you prevail in the event of such scrutiny.
Have questions about reasonable rent? Let’s talk!