Plentywood, MT pharmacy rent expenses. The US Tax Court recently heard a case where a Montana pharmacy located in Plentywood, Montana, population 1,700, paid rent for a building owned by the same people that owned the pharmacy. While rent is typically a deductible expense, that is not necessarily the case when the parties are closely related.
The Tax Court pointed out:
When there is a close relationship between lessor and lessee and in addition there is no arm’s length dealing between them, an inquiry into what constitutes reasonable rental is necessary to determine whether the sum paid is in excess of what the lessee would have been required to pay had he dealt at arm’s length with a stranger.
Was “rent” used to avoid double taxation of a C corporation? The pharmacy was owned by a C corporation. Thus, it is subject to double taxation. The first tax is income tax on the income of the corporation and the second tax is at the shareholder level on dividends paid by the corporation. The corporation is not entitled to deductions on the dividends paid to shareholders. On the other hand, ordinary and necessary business expenses are deductible by the corporation and not subject to income tax. However, the taxpayers in this case were not able to deduct the full amount of the rent paid as a business expense. The owners of corporation (the shareholders) were the same individuals that owned the building that was rented to the corporation. The IRS audited and recharacterized some of the rent as constructive dividends. The taxpayers (the individual shareholders and the corporation) appealed to US Tax Court.
Expert testimony on amount of rent. The Tax Court reviewed expert witness testimony from both sides on the subject of reasonable rent. The problem with expert testimony is that there were not other comparable commercial rentals in Plentywood. The taxpayer’s witnesses mostly used comparable properties from Williston, an oil booming town that is much larger. The IRS’s witness used apartment buildings and a small donut shop as comparables. The judge determined the proposed comparables from both witnesses were unreliable and used the only other rental in the town that was the approximate same size—the post office. After making some adjustments, the Tax Court lowered the rent in favor of the government and determined that the excess rent was nondeductible constructive dividend. However, the Tax Court did throw out accuracy related penalties on grounds the IRS had not followed the correct procedure in imposing them and for other reasons.
Practice point. Beware of transactions between closely related parties. Taxpayers should document independent evidence of value to more appropriately determine the value of rent when the lessor and lessee are related parties. The IRS may scrutinize related party transactions.
Also, even if the taxpayer is located in remote Plentywood, MT, that does not mean that he or she is will fly under the radar of the IRS. The IRS has income tax auditors throughout the state of Montana, along with North Dakota and Wyoming. The case does not mention why the income tax return was selected for audit. Do not expect that being a small Montana business will insulate the taxpayer from audit.
Taxpayers involved with tax audits and appeals may contact Jared Le Fevre to discuss options for defending against the IRS.
About the Author. Jared M. Le Fevre is a Partner in the Tax, Trusts and Estates Practice Group of Crowley Fleck PLLP. Mr. Le Fevre represents taxpayers before the IRS, IRS Independent Office of Appeals, US Tax Court, Federal District Court and state tax agencies throughout Montana, Wyoming, North Dakota, Idaho, and Utah. Mr. Le Fevre is involved in federal, state and local tax audits, appeals, and tax resolution throughout these western states. Mr. Le Fevre also advises clients on the tax effects of business and real estate transactions.
 Plentywood Drug, Inc. v. Comm’r of Internal Revenue, T.C.M. (RIA) 2021-045 (T.C. 2021).