T.C. Memo. 2009-107
UNITED STATES TAX COURT
HOPKINS PARTNERS, CLEVELAND AIRPORT HOTEL LIMITED PARTNERSHIP,
TAX MATTERS PARTNER, ET AL.,1 Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
Docket Nos. 19563-04, 17269-05, Filed May 19, 2009.
19877-05.
Stephen L. Kadish, Matthew F. Kadish, and Aaron H. Bulloff,
for petitioner.
John Tkacik, Jr., for respondent.
1
Cases of the following petitioners are consolidated for
purposes of trial, briefing, and opinion: Hopkins Airport Hotel
Partnership, Cleveland Airport Hotel Limited Partnership, Tax
Matters Partner, docket No. 17269-05; and Hopkins Partners,
Cleveland Airport Hotel Limited Partnership, Tax Matters Partner,
docket No. 19877-05. These cases are collectively referred to
herein as “case”.
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MEMORANDUM FINDINGS OF FACT AND OPINION
WELLS, Judge: In the instant case, respondent issued
notices of final partnership administrative adjustment in which
he determined adjustments of $2,323,107, $274,130, $280,685, and
$225,469 increasing the income of Hopkins Partners (partnership)2
for taxable years 2000, 2001, 2002, and 2003 respectively. The
issues to be decided are: (1) Whether certain leasehold
improvements made by the partnership were substitutes for rent;
and (2) if so, (a) whether the deductibility of improvements made
in lieu of rent is limited to the early period of the lease or to
a certain fraction of the total rent expense; (b) whether the
transfer of the improvements in issue was illusory; (c) whether
the rent credit arrangement in issue (rent credit) lacked
economic substance; (d) whether the use of the rent credits was a
clear reflection of income; (e) whether the use of the rent
credits was an accounting method change; and (f) whether
respondent properly proposed an adjustment under section 481(a)3
for taxable year 2000.
2
For purposes of the instant case, references to the
partnership include Hopkins Partners and its predecessors-in-
interest.
3
Unless otherwise indicated, all section references are to
the Internal Revenue Code, as amended, and all Rule references
are to the Tax Court Rules of Practice and Procedure.
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FINDINGS OF FACT
Some of the facts and certain exhibits have been stipulated.
The stipulations of fact are incorporated in this opinion by
reference and are found as facts.
The partnership is an Ohio general partnership formed on
September 28, 1995.
The partnership operates the Sheraton Cleveland Airport
Hotel (hotel). The hotel is at Cleveland Hopkins International
Airport (airport) and is owned by the City of Cleveland, Ohio
(city).
The partnership operates the hotel and attendant parking
facilities under a leasehold interest assigned to it by its
immediate predecessor-in-interest. The leasehold interest was
created by a lease from the city to a predecessor-in-interest to
the partnership during 1957. Thereafter, various entities which
were predecessors-in-interest to the partnership held the
leasehold/operator interest through a series of lease concessions
and modifications between 1957 and 1990.
The partnership currently has the leasehold right to
operate the hotel through November 13, 2048.
The Early Leases
The first lease, the Lease by Way of Concession for a Hotel
at Cleveland-Hopkins Airport (1957 lease), was executed on
December 12, 1957.
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The 1957 lease required the partnership to construct and
operate a hotel on the airport premises. The 1957 lease had a
total term of 31 years, 4 months.
Under the 1957 lease, title to the hotel passed immediately
to the city, and upon termination of the 1957 lease, the hotel
premises and all structures and improvements thereon were to
remain the property of the city with the exception of furniture,
furnishings, fixtures, and equipment that were the personal
property of the partnership. After the initial 16-month term,
the 1957 lease required the partnership to pay rent of the
greater of $4,800 per year or a percentage of gross receipts.
The Supplemental Lease by Way of Concession dated July 30,
1962 (supplemental lease), gave the partnership the use of
additional land to be used as parking for customers, and the
right to sell food and beverages. The supplemental lease also
increased the minimum annual rent to $6,000 per year.
The Second Supplemental Lease dated November 14, 1966
(second supplemental lease), provided additional land for
parking; increased the minimum annual rental to $75,000; and
extended the term to 35 years from the date of execution. The
second supplemental lease also required the partnership to
construct an addition to the hotel and to spend $2.8 million on
improvements over 5 years.
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The Third Supplemental Lease dated March 6, 1969 (third
supplemental lease), allowed the partnership to construct hotel
additions or improvements on land previously designated for
parking.
The Fourth Supplement to Lease by Way of Concession dated
January 26, 1984 (fourth supplemental lease), extended the term
of the 1957 lease through November 13, 2023, and required the
partnership to spend at least $1.25 million on improvements in
the initial 5-year period of the fourth supplemental lease and
$500,000 on improvements in each subsequent 5-year period. The
fourth supplemental lease also provided that all furniture and
fixtures would become the property of the city upon termination
of the 1957 lease, as amended. The minimum annual rent under the
fourth supplemental lease was increased to $150,000 for the
initial year of the fourth supplemental lease and was to increase
by an additional $9,000 in each subsequent year of the fourth
supplemental lease.
The Negotiation of Rent Credits
During the mid-to-late 1980s, the city was enjoying a
business and civic rejuvenation following a difficult period.
New highway construction facilitated access to the airport. At
the same time, the hotel had fallen into disrepair.
The partnership was losing significant amounts of money on
the hotel, with projected losses in excess of $500,000 each year
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through 1997. The partnership was looking for a way to make the
hotel profitable. The partnership believed that the rent under
the 1969 lease was significantly above the prevailing market
rate, and it was seeking rent relief to achieve its objective of
making the hotel profitable.
The city was concerned about the condition of the hotel
because the hotel was a visitor’s first impression of Cleveland.
The city wanted the hotel renovated to address the city’s
concerns and threatened to allow construction of a second hotel
on the airport premises if the partnership failed to renovate the
hotel. Construction of a second hotel on the airport premises
would have put the partnership out of business.
The partnership did not have sufficient cash to make
improvements to the hotel, so it attempted to expand its mortgage
to cover the cost of improvements. The lender, American Real
Estate Group, indicated that it believed the land rent on the
hotel was substantially above market and conditioned any
additional advance of funds on a substantial reduction in the
land rent.
During 1987, the partnership informed the city that the
partnership was unable to borrow additional funds to cover the
cost of necessary repairs and improvements to the hotel. The
partnership proposed a modification of the lease which would have
increased the minimum annual rent to $300,000 but would have
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decreased the percentage rent. The proposed change was expected
to result in an overall decrease in rent.
Negotiations regarding the proposed improvements and the
change to the rent under the lease ensued between the partnership
and the city. The city was in a strong negotiating position
because the economic climate in the city at that time was
conducive to finding a new operator to construct and operate a
new hotel if the city did not obtain the renovations the city
wanted.
The partnership submitted to the city a modified proposal in
which it again requested that the rent be reduced or, in the
alternative, that the cost of improvements be credited against
any land rent in excess of $300,000 per year. The city rejected
that proposal but later submitted a counterproposal adopting the
rent credit approach. The counterproposal allowed the
partnership to credit the cost of certain eligible improvements
against annual rent in excess of $300,000. The partnership
accepted the counterproposal subject to requested changes.
The partnership was concerned with the profitability (or
lack thereof) of the hotel and was agreeable to using either a
rent reduction or rent credits to achieve its goal of making the
hotel profitable. However, the parties believed that the
Cleveland City Council, which had to adopt an ordinance approving
any lease modification, was unlikely to agree to a rent
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reduction. Additionally, the parties believed that it was more
efficient for the partnership to make improvements than for the
city to do so because it avoided the necessity of the City
Council’s having to approve each step of those improvements. The
ultimate decision to structure the leases to include rent credits
rather than a rent reduction was motivated by the foregoing
concerns, not by tax considerations.
The 1989 Lease Supplement
The Sixth Supplement to Lease by Way of Concession, dated
August 11, 1989 (1989 lease supplement), increased the minimum
annual rent from $195,000 to $300,000. The percentage rent
remained unchanged. However, the 1989 lease supplement entitled
the partnership to credits against the percentage rent for
certain eligible improvements. Eligible improvements were
defined in the 1989 lease supplement and were subject to approval
by the city. The partnership was required to spend at least
$900,000 every 3 years on eligible improvements. The rent credit
in any given year was capped at $400,000, but any eligible
improvements made in excess of that limit could be carried
forward to future years.
The 1990 Amended Lease
The partnership and the city executed the Amended and
Restated Lease by Way of Concession dated December 31, 1990 (1990
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amended lease). The 1990 amended lease was effective during the
years at issue and remains in effect through trial.
The 1990 amended lease extended the term of the 1957 lease
for an additional 35 years. It also permitted the partnership to
demolish a portion of the hotel and to convert that area into a
parking lot for hotel patrons and public parking patrons.
The 1990 amended lease required the partnership to renovate
the hotel tower at a minimum cost of $5 million. The costs
related to the renovation were subject to approval by the city
and were eligible for rent credits. Additionally, the 1990
amended lease required the partnership to spend $1.5 million on
improvements every 3 years. Those expenditures also qualified
for rent credits.
The 1990 amended lease increased the maximum amount of rent
credit in any given year to $650,000 and allowed any eligible
improvements made in excess of that limit to be carried forward
to future years.
The Parking Lease
The partnership and the city also entered into a separate
Amended and Restated Lease by Way of Concession dated December
31, 1990 (parking lease), allowing the partnership to operate a
parking lot on the hotel property. The parking lease was in
effect during the years in issue and remained in effect through
trial.
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The parking lease required the partnership to demolish a
portion of the hotel and in its place to construct and operate a
parking lot and parking facility.
The parking lease required the partnership to pay annual
rent equal to the greater of $100,000 or 10 percent of the gross
revenues from parking operations.
The parking lease allowed the partnership a credit against
percentage rent for eligible improvements. Any eligible
improvements in excess of percentage rent in a given year could
be carried forward to be used as a credit against percentage rent
in subsequent years.
The 1989 lease supplement, the 1990 amended lease, and the
parking lease are sometimes hereinafter referred to collectively
as the lease agreements.
The Rent Credit Process
At the start of each year the partnership provided the city
with a detailed list of planned eligible improvements. The city
had the right to reject planned improvements and occasionally did
so. Pursuant to the lease agreements, a failure to comment by
the city was deemed an approval.
At the end of each year the partnership submitted to the
city a detailed list of expenditures along with documentation of
those expenditures. Pursuant to the lease agreements the city
had the right to audit the detailed list of expenditures and
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occasionally rejected items from the list. Eventually, the
partnership and the city agreed on what qualified as eligible
improvements for that year.
Each year the partnership decided which eligible
improvements the partnership would use for rent credit. The
partnership documented the eligible improvements the partnership
was using to obtain rent credit on a detailed spread sheet
provided to the city. In accordance with the lease agreements,
title to the eligible improvements vested in the city at the end
of the year in which those improvements were credited against
rent.
Generally, the partnership elected to receive rent credits
for leasehold improvements rather than furniture, fixtures, and
equipment (FF&E). The partnership made that election in order to
avoid the detailed inventory tracking requirements and the
burdensome and unsightly tagging associated with FF&E.
When the partnership made eligible improvements, it
accounted for them by recording them on its books as capital
assets. Where the partnership received a credit against rent for
the full cost of an eligible improvement in the year that the
improvement was made, it deducted that cost as a rent expense on
its Federal income tax return for that year. When an eligible
improvement was not credited against rent in the year it was
made, the partnership kept that eligible improvement on the books
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as a capital asset and depreciated that asset in accordance with
sections 167 and 168. When the partnership received a rent
credit for an eligible improvement for which it had claimed a
depreciation deduction in a previous year, it treated that as a
sale of the eligible improvement for an amount equal to the rent
credit and recognized gain, including depreciation recapture, as
applicable. The partnership then deducted the cost of the
eligible improvement as a rent expense in the year in which it
was credited against rent.4
The partnership consistently followed the above procedure
and that procedure was reviewed by two independent accounting
firms.
OPINION
I. Whether the Leasehold Improvements Were a Substitute for
Rent
As a general rule, the Commissioner’s determinations are
presumed correct and the burden of proving an error is on the
4
Respondent disallowed the partnership’s deduction of the
cost of eligible improvements as a rent expense in all instances
whether the deduction was claimed in the year the improvements
were made or in a later year. Respondent’s arguments, however,
do not distinguish between the two situations, and we note that
not all of the arguments are equally applicable to instances
where the cost of eligible improvements was deducted in the year
they were made (and so were never depreciated) and instances
where the partnership depreciated the improvements before using
them for rent credit. Since we are not convinced by any of
respondent’s arguments, we need not consider whether any of the
arguments are a basis for disallowing the deduction in one
instance but not in the other.
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taxpayer. Rule 142(a); Welch v. Helvering, 290 U.S. 111, 115
(1933). In the instant case, the parties agree that petitioner
has the burden of proof.
Generally, section 162(a) allows as a current deduction from
gross income all the ordinary and necessary expenses incurred in
carrying on a trade or business. However, sections 161 and 261
have the effect of subordinating provisions such as section
162(a) to provisions such as section 263(a)(1), thereby
disallowing the current deduction of capital expenditures that
otherwise would have been currently deductible trade or business
expenses. Commissioner v. Idaho Power Co., 418 U.S. 1, 17
(1974). Unless some other special rule applies (see, e.g.,
section 263(a)(1)), a taxpayer’s deductions for capital
expenditures, if allowable at all, generally come by way of
amortization or depreciation; i.e., the capital expenditure is
deductible over a period of time. Secs. 167, 168, and 169;
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 83 (1992).
Capital expenditures are, with limited exceptions, any
amounts paid out for new buildings, permanent improvements, and
restoration. Sec. 263(a). The parties agree that the eligible
improvements in issue are capital expenditures within the meaning
of section 263(a).
A taxpayer’s entitlement to depreciation deductions for
leasehold improvements hinges not on legal title but on a
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recognized investment in the property. Gladding Dry Goods Co. v.
Commissioner, 2 B.T.A. 336, 338 (1925); see also Mayerson v.
Commissioner, 47 T.C. 340, 350 (1966). Consequently, the
important question is whether the taxpayer made an investment of
capital that the taxpayer is entitled to recover. Gladding Dry
Goods Co. v. Commissioner, supra at 338 (“The one who made the
investment is entitled to its return.”). If a lessor makes
improvements at the lessor’s own expense, the lessor is entitled
to depreciation deductions despite the fact that the lessee has
the use and enjoyment of the improvements. Id. If a lessee
makes improvements and the title to the improvements vests
immediately in the lessor, the lessor’s bare legal title does not
preclude the lessee from recovering that lessee’s investment
through depreciation deductions. Id.
Generally, where a lessee makes and invests in improvements
on the property leased by the lessee, the lessee is entitled to
recover that investment through depreciation deductions rather
than through a current business expense deduction. Sec. 1.162-
11(b), Income Tax Regs. There is, however, an exception where a
lessee places improvements on real estate that constitute a
substitute for rent. In that case, section 1.61-8(c), Income Tax
Regs., provides that the cost of the improvements made in lieu of
rent is rental income to the lessor. Section 1.61-8(c), Income
Tax Regs., expressly addresses only the amount to be included in
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the income of the lessor; it does not address the amounts, if
any, that are deductible by the lessee. However, section 1.61-
8(c), Income Tax Regs., does make clear that improvements in lieu
of rent are rental income to the lessor, and rent is a currently
deductible expense for a lessee under section 162(a)(3).
Additionally, caselaw provides that, where an improvement is in
lieu of rent, the amount invested in the improvement is currently
deductible by the lessee as a rent expense. Your Health Club,
Inc. v. Commissioner, 4 T.C. 385, 390 (1944); McGrath v.
Commissioner, T.C. Memo. 2002-231, affd. without published
opinion 92 AFTR 2d 6159, 2003-2 USTC par. 50,663 (5th Cir. 2003).
Where improvements are in lieu of rent, the cost of those
improvements is actually borne by the lessor through the rent
credit, and the lessee has no capital investment to depreciate.
Your Health Club, Inc. v. Commissioner, supra at 390.
Whether the value of improvements constitutes rent turns
upon the intent of the parties to the lease. M.E. Blatt Co. v.
United States, 305 U.S. 267, 277 (1938); Cunningham v.
Commissioner, 28 T.C. 670, 680 (1957), affd. 258 F.2d 231 (9th
Cir. 1958); McGrath v. Commissioner, supra; see also sec. 1.61-
8(c), Income Tax Regs. The intent of the parties to the lease is
derived from the terms of the lease as well as the surrounding
circumstances. Cunningham v. Commissioner, supra at 680; sec.
1.61-8(c), Income Tax Regs. Even when the improvements are
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required by the terms of the lease, they will not be deemed rent
unless the intention of the parties to the lease to treat them as
rent is plainly disclosed. M.E. Blatt Co. v. United States,
supra at 277.
We consider in the instant case whether the partnership and
the city intended that the eligible improvements be a substitute
for rent. Respondent contends that petitioner failed to
introduce evidence of the city’s intent with respect to the lease
agreements, alleging that petitioner relied only on the self-
serving testimony of its own agents.5
Petitioner did introduce evidence of the intent of the
parties to the lease agreements, most notably the lease
agreements themselves. Additionally, petitioner introduced the
testimony of credible witnesses regarding the lease negotiations
and the circumstances surrounding those negotiations. Respondent
did not discredit those witnesses at trial, nor did respondent
introduce witnesses to rebut the testimony of petitioner’s
witnesses.
5
Respondent also asserts that petitioner’s failure to
introduce testimony from the city gives rise to an inference
under Wichita Terminal Elevator Co. v. Commissioner, 6 T.C. 1158,
1165 (1946), affd. 162 F.2d 513 (10th Cir. 1947), that the
testimony would have been unfavorable. However, Wichita Terminal
applies to “the failure of a party to introduce evidence within
his possession”. Id. (emphasis added). It is inapplicable in
this case because petitioner has shown that testimony of the
city’s agents who negotiated the lease agreements was
unavailable.
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In deciding the intent of the parties to the lease
agreements, we first look at the express terms of the documents.
Article IV.D of the 1990 amended lease states that the
partnership “shall be entitled to receive a credit towards the
payment of the annual Percentage Rent, in an amount equal to the
cost of eligible improvements * * * which have been made and paid
for prior to the completion of the lease year”. The parking
lease, in article IV, paragraph A.5, provides that the
partnership “may deduct the cost of eligible improvements made
and paid for in a lease year from any Percentage Rent due for
that lease year.” In Brown v. Commissioner, 22 T.C. 147, 148
(1954), affd. 220 F.2d 12 (7th Cir. 1955), we held that a similar
provision requiring that the cost of improvements “‘be credited
to the Lessee from the rental due and owing by it under this
lease’” resulted in income to the lessor. The express language
of the lease agreements clearly indicates that the parties to
those documents intended that the partnership’s expenditures for
eligible improvements were in lieu of its payment of percentage
rent.
When determining whether the parties to the lease intended
to treat the cost of improvements as a substitute for rent,
consideration must be given to the surrounding circumstances in
addition to the express language of the particular lease.
Cunningham v. Commissioner, supra at 680. One relevant factor is
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how the parties to the lease treated the expenditure for tax
purposes over the course of the lease. Brown v. Commissioner,
220 F.2d at 17 (lessee treated the cost of improvements as a rent
expense, and the improvements were held to be a rent substitute);
Cunningham v. Commissioner, supra at 681 (lessee treated the cost
of improvements as a capital expense, not a rent expense, and the
improvements were held not to be a rent substitute). In the
instant case, the partnership consistently treated the eligible
improvements, both on its books and in its tax returns, as a
deductible rent expense in the year that it obtained a rent
credit for the cost of those eligible improvements. That
treatment is consistent with the express language of the lease
agreements indicating that the eligible improvements were
intended by the parties to the lease agreements to be in lieu of
rent.
Respondent further argues that “Petitioner’s claim that it
was the intent of the parties to the lease that the petitioner’s
capital expenditures were to be made in lieu of rent is further
undermined by the fact that the city * * * was a tax indifferent
party”, citing CMA Consol., Inc. v. Commissioner, T.C. Memo.
2005-16. In CMA Consolidated, the presence of a tax indifferent
party was a consideration in deciding whether the transaction
lacked economic substance, but it is not probative on how the
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parties intended to structure the transaction.6 In the instant
case, respondent has cited no case standing for the proposition
that tax indifference is a consideration in deciding whether the
parties to a lease intended capital expenditures to be made in
lieu of rent. However, we have considered the tax indifference
of the city, and we are persuaded by the record that the city’s
tax indifference did not play a significant role in the
negotiations between the city and the partnership or the city’s
intent regarding the provisions of the lease agreements.
Accordingly, we conclude that the parties to the lease
agreements intended, as evidenced by the express language of the
leases and the surrounding circumstances, that the eligible
improvements be substitutes for rent. Notwithstanding the intent
of the parties to the lease agreements to treat the eligible
improvements as substitutes for rent, respondent advances several
reasons the eligible improvements should not be treated as
deductible rent expenses. We address each of these contentions
below.
II. Whether Rent Credits Must Be Limited in Duration or Amount
Respondent contends that Your Health Club, Inc. v.
Commissioner, 4 T.C. 385 (1944) and McGrath v. Commissioner, T.C.
Memo. 2002-231 “can clearly be distinguished in that the rent
6
We address the issue of economic substance below in sec.
IV.
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substitute in both cases was limited to the initial start-up
period of the business and the rent substitute made up only a
small fraction of the amount claimed as a deduction for rent
expense.” While respondent correctly points out that in Your
Health Club, Inc. the rent credit was limited to the initial year
of the lease and was just under one-third of the total rent
deduction for that year, those limits were imposed by the parties
to the lease. In Your Health Club, Inc. this Court had no reason
to consider a larger credit, and we in no way indicated that a
larger credit would have been impermissible. In McGrath this
Court did limit the amount allowed as a rent substitute. That
limitation, however, was based on the intent of the parties to
the lease, not on a decision that a larger or longer term rent
credit would in all cases be impermissible or incorrect depending
on the intent of the parties to other such leases. In McGrath we
explicitly concluded that neither the lease nor the surrounding
circumstances showed that the parties to the lease intended to
treat the entire cost of the improvements as a rent substitute.
As discussed above, in the instant case, the parties to the lease
agreements did intend to treat the eligible improvements as a
substitute for rent to the extent of the percentage rent each
year. Accordingly, we conclude that respondent’s argument that
rent credits should be limited in duration and amount is not
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supported by the cited cases and is inconsistent with the intent
of the parties to the lease agreements.
III. Whether the Transfer of Eligible Improvements Was Illusory
In accordance with article VII.A of the 1990 amended lease
and article VII.A of the parking lease, title to eligible
improvements vested in the city in the year that those
improvements were credited against rent, and the partnership
treated each transfer as a deemed sale of the eligible
improvement to the city in exchange for the rent credit.
Respondent contends that the partnership’s transfers of eligible
improvements in exchange for rent credits were illusory. In
support of that contention, respondent notes that the partnership
retained control over and the right to the use of the transferred
eligible improvements. Additionally, respondent contends that
the partnership could not transfer the eligible improvements to
the city because, under the lease agreements, title to those
improvements would vest in the city at the end of the lease.
In deciding whether there has been a sale or exchange
sufficient to transfer the depreciable interest in an asset from
one taxpayer to another, this Court has looked at whether there
was a transfer of the benefits and burdens of ownership. Grodt &
McKay Realty, Inc. v. Commissioner, 77 T.C. 1221, 1237 (1981).
Grodt & McKay Realty, Inc. lists several factors relevant in
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determining where the benefits and burdens lie.7 In the case of
leasehold improvements, the balancing factors have been refined
by caselaw and the regulations, which provide us with significant
guidance in deciding whether the benefits and burdens (and thus
the depreciable interest) lie with the lessor or the lessee.
Depreciation is not predicated upon ownership of property
but rather upon an investment in the property. Mayerson v.
Commissioner, 47 T.C. 340 (1966) (citing Gladding Dry Goods Co.
v. Commissioner, 2 B.T.A. 336 (1925)). Where leasehold
improvements are involved, legal title and the right of
possession and enjoyment are not determinative; the important
question is whether the lessor or the lessee made the investment
in those improvements. Gladding Dry Goods Co. v. Commissioner,
supra at 338. Generally, where the lessor makes improvements at
the lessor’s own expense, it is the lessor that has a depreciable
interest in the improvements. Id. If the lessee makes
improvements at the lessee’s expense, it is generally the lessee
that has a depreciable interest in the improvements. Id.; sec.
7
These factors include: (1) Which party to the transaction
has legal title; (2) how the parties to the transaction treated
the transaction; (3) whether equity was acquired by the
purchaser; (4) whether the purchaser was required to make a
present payment; (5) which party to the transaction had the right
of possession; (6) which party to the transaction paid property
taxes; (7) which party to the transaction bore the risk of loss;
and (8) which party to the transaction received the profits
generated by the property. Grodt & McKay Realty, Inc. v.
Commissioner, 77 T.C. 1221, 1237-1238 (1981).
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1.162-11(b), Income Tax Regs. However, where a lessee makes
improvements as a substitute for rent, the lessee has no
depreciable interest in those improvements. Your Health Club,
Inc. v. Commissioner, supra at 390. Such a transaction is not
different from one where the lessor paid for the improvements
directly and the lessee paid the full rent. Id. When the lessor
bears the cost of improvements via a rent credit, the lessor has
an increased investment in the property, resulting in a higher
basis and increased depreciation deductions. Brown v.
Commissioner, 22 T.C. at 151.
In the instant case, the partnership made the eligible
improvements at its own expense. To the extent that it received
a rent credit in the year it made the improvements, it
appropriately treated the cost of those improvements as a rent
expense and deducted that cost currently. See Your Health Club,
Inc. v. Commissioner, 4 T.C. 385 (1944). To the extent that the
partnership did not receive a rent credit in the year that it
made the eligible improvements, it had a depreciable interest in
those improvements.8 See Gladding Dry Goods Co. v.
8
We note that had the eligible improvements been considered
advance rent, the lessor would presumably have had the
depreciable interest in those eligible improvements beginning in
the year that they were made. However, because the partnership
often made eligible improvements in excess of those required
under the lease, it was not certain which eligible improvements
would eventually be credited against rent. Accordingly, we
conclude that the eligible improvements were not advance rent
(continued...)
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Commissioner, supra at 338. When the city credited the cost of
an eligible improvement made in an earlier year against the
partnership’s rent, the city assumed the cost of that
improvement, and the depreciable interest in that eligible
improvement was transferred from the partnership to the city.
With the cost of that improvement now borne by the city through
the rent credit, the partnership no longer had a capital
investment to depreciate. See Your Health Club v. Commissioner,
supra. Accordingly, we conclude that the benefits and burdens
surrounding the eligible improvements shifted from the
partnership to the city in the year those improvements were
“transferred” and credited against rent.
The partnership properly treated the transfer of its
depreciable interest to the city in exchange for a rent credit as
a deemed sale. See United States v. Gen. Shoe Corp., 282 F.2d 9
(6th Cir. 1960). The partnership claimed a rent expense
deduction equal to the rent credit it received and treated the
amount of that rent credit as the amount it realized on the
transfer. The partnership recognized gain to the extent that the
rent credit exceeded its depreciated basis in the eligible
improvement and effectively recaptured any depreciation claimed
on the eligible improvement in prior years.
8
(...continued)
paid in the year they were made.
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IV. Whether the Rent Credit Arrangement Lacked Economic
Substance
Even where a transaction complies with the formal
requirements for obtaining a deduction, courts have long looked
beyond that formal compliance and analyzed the substance of the
transaction. Knetsch v. United States, 364 U.S. 361 (1960);
Gregory v. Helvering, 293 U.S. 465 (1935). The taxpayer has the
burden of showing that the form of the transaction accurately
reflects its substance and that the deduction is permissible.
IRS v. CM Holdings, Inc., 301 F.3d 96, 102 (3d Cir. 2002).
In the instant case, respondent contends that the rent
credit provisions in issue lacked economic substance and were
not part of a bona fide business transaction. In considering
whether a transaction has economic substance, courts look at both
the objective economic effect (i.e. whether, absent tax benefits,
the taxpayer benefited from the transaction) and the subjective
business motivation (i.e. whether the taxpayer was motivated by
considerations beyond tax benefits) of the transaction. Id.
In the instant case, the hotel was not profitable and was in
need of renovation in order to have any hope of becoming
profitable. The partnership did not have the funds to renovate
the hotel and was unable to borrow funds for the renovations with
the lease arrangement structured as it was before 1989. With the
introduction of rent credits in the 1989 lease, the annual
percentage rent did not change. However, the partnership was
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able to make improvements to the hotel and credit those
improvements against its rent for the year. Clearly, the rent
credits provided a financial benefit to the partnership in that
the partnership obtained the improvements that it wanted and
needed and could reduce its rent on the basis of its cash outlay
for the improvements. The negotiation of the lease agreements to
include rent credits provided the partnership with a significant
benefit independent of any tax considerations.
Petitioner’s witnesses testified that the partnership’s goal
in negotiating rent credits was to find a way to make the
improvements to help it make a profit on the hotel. Petitioner’s
witnesses also credibly testified that tax considerations were
not discussed at the time of the negotiations and that it was
only later that the partnership considered how the rent credits
would be handled for tax purposes.
Petitioner also introduced credible testimony that the
parties to the lease agreements chose rent credits over other
alternatives for business, not tax, reasons. The mentioned
alternatives were for the city to make the improvements at its
own expense or to grant the partnership reduced rent and allow
(or require) the partnership to make the improvements. Regarding
the first alternative, there was concern that the City Council
would be unwilling to approve a rent reduction. There was also
concern that, if the city made the improvements, it would involve
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a cumbersome process of obtaining City Council approval
repeatedly rather than the single City Council approval needed to
modify the lease to include rent credits for improvements made by
the partnership. The record shows and we conclude that the
partnership’s motivation in negotiating rent credits was to turn
the hotel into a profitable enterprise and that the parties to
the lease agreements had valid business reasons for choosing the
rent credit structure over a lease providing for reduced rent.
Respondent makes much of the fact that the city is tax
exempt. Where one of the parties is tax exempt, as is the city,
there is potential for abuse. However, respondent points to no
authority that would support a holding that a transaction
involving a tax-exempt party cannot have economic substance.
Respondent asserts that a taxable entity similarly situated with
the city would not have accepted the lease terms involving rent
credits. However, it is clear from the evidence that the city
wanted to see the hotel renovated and was not simply going along
with the partnership’s proposal. For the reasons discussed
above, we conclude that a taxable entity in the city’s position
could have favored the rent credit structure for business
reasons, despite that fact that another structure might have
produced greater tax savings for it.
We conclude that tax considerations were not a significant
motivating factor in the negotiation of the rent credits. On the
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basis of the record, we conclude that the rent credit
arrangements in issue had a subjective business purpose. We also
conclude that the rent credit arrangement had objective economic
substance.
V. Whether the Use of Rent Credits Clearly Reflected Income
If a taxpayer’s method of accounting does not clearly
reflect income, section 446(b) allows the Commissioner to compute
taxable income under such method as, in the opinion of the
Commissioner, does clearly reflect income. In the instant case,
respondent asserts that the partnership’s use of rent credits
does not clearly reflect income because it “converts depreciable
property to rent expense, computed at the historical cost of the
asset, thereby inflating its deductions that significantly
reduces taxable income”. Respondent further alleges that the
partnership is “clearly understating income” by taking a current
deduction for the cost of long-term eligible improvements.
As respondent notes, a method of accounting clearly reflects
income when it results in accurately reporting taxable income
under a recognized method of accounting. RLC Indus. Co. & Subs.
v. Commissioner, 98 T.C. 457, 491 (1992), affd. 58 F.3d 413 (9th
Cir. 1995). “The Commissioner’s determination with respect to
clear reflection of income is entitled to more than the usual
presumption of correctness, and the taxpayer bears a heavy burden
of overcoming a determination that a method of accounting does
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not clearly reflect income.” Hamilton Indus., Inc. v.
Commissioner, 97 T.C. 120, 128 (1991). The Commissioner has
broad discretion but cannot require a taxpayer to change from an
accounting method that clearly reflects income merely because the
Commissioner considers an alternate method to more clearly
reflect income. RLC Indus. Co. & Subs. v. Commissioner, supra at
491. If a taxpayer’s method of accounting is authorized by the
Internal Revenue Code or the underlying regulations and has been
applied consistently, the Commissioner cannot arbitrarily require
a change or reject the taxpayer’s method. Id. We review
respondent’s determination for abuse of discretion. See Thor
Power Tool Co. v. Commissioner, 439 U.S. 522 (1979).
As discussed above, the method of treating the cost of
improvements credited against rent as a deductible rent expense
has been accepted by both the courts and the regulations. See
Your Health Club, Inc. v. Commissioner, 4 T.C. at 390; McGrath v.
Commissioner, T.C. Memo. 2002-231; sec. 1.61-8(c), Income Tax
Regs. In the instant case, respondent correctly points out that
by treating the cost of improvements as a rent expense rather
than depreciating (or continuing to depreciate) the costs, the
partnership does increase its current deductions and reduce its
taxable income in the year of the rent credit. However, since
the partnership consistently accounted for its eligible
improvements using an approved accounting method, respondent is
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not at liberty to require the partnership to use a different
method of accounting, even if respondent believes that another
method would more clearly reflect income.9 See RLC Indus. Co. &
Subs. v. Commissioner, supra at 491.
Respondent’s concern with the use of historical cost is
unfounded. It is true that if the eligible improvements were not
credited against rent in the year made, the partnership initially
depreciated them. However, in the year that the partnership
received a rent credit for the eligible improvements, the
partnership treated that as a deemed sale of the capital asset
for an amount equal to the rent credit it received, which was
equal to the historical cost of the eligible improvement. By
recognizing gain to the extent that the rent credit exceeded the
partnership’s depreciated basis in the eligible improvement, the
partnership effectively recaptured any depreciation it had
previously claimed on that improvement. See United States v.
Gen. Shoe Corp., 282 F.2d at 12-13. By doing so, the partnership
received the same deduction that it would have received if that
eligible improvement had been credited against rent in the year
it was made. Accordingly, the use of rent credits computed at
9
Respondent’s proposed accounting method would have the
partnership continue to depreciate the eligible improvements even
after they are credited against rent. Because the partnership no
longer had a depreciable interest in the eligible improvements at
that point, respondent’s proposed method of accounting is not an
authorized method of accounting and would not be a clear
reflection of the partnership’s income.
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the historical cost of the improvements did not inappropriately
increase the overall deductions; it merely accelerated the time
at which the partnership claimed those deductions. While such an
acceleration generally would not be permissible for a capital
asset, as discussed above, there is an exception that applies in
the instant cases that allows the current deduction of capital
expenses that are incurred and credited as a substitute for rent.
See Your Health Club, Inc. v. Commissioner, supra at 390; McGrath
v. Commissioner, supra; sec. 1.61-8(c), Income Tax Regs.
Accordingly, we conclude that the partnership’s method of
accounting for eligible improvements made in lieu of rent did
clearly reflect income and that respondent abused his discretion
in determining that the partnership’s method did not clearly
reflect income.
VI. Whether the Use of Rent Credits Was an Accounting Method
Change
Section 446(e) provides that a taxpayer must secure the
consent of the Secretary before changing his method of
accounting.
The reason for this rule is that a change in an
accounting method will frequently cause a distortion of
taxable income in the year of change; therefore, the
Commissioner is empowered to prevent such distortion
and consequent windfall to the taxpayer by conditioning
his consent on the taxpayer’s acceptance of adjustments
that would eliminate any distortion. * * * [Woodward
Iron Co. v. United States, 396 F.2d 552, 554 (5th Cir.
1968).]
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In the instant case, respondent contends that the
partnership’s change from depreciating to deducting the cost of
an eligible improvement in the year in which the partnership
received a rent credit for such improvement is a change in
accounting method. We disagree because, as discussed above, when
the partnership received a rent credit for the cost of an
eligible improvement, the depreciable interest in that eligible
improvement was transferred from the partnership to the city. At
that point, the partnership, as required by law, see Your Health
Club v. Commissioner, supra at 390; Gladding Dry Goods v.
Commissioner, 2 B.T.A. at 338, discontinued depreciating the
eligible improvement because it no longer had an investment to
depreciate. In the same year, the partnership deducted as a rent
expense, as it was entitled to do by law, see Your Health Club,
Inc. v. Commissioner, supra at 390; McGrath v. Commissioner,
supra; sec. 1.61-8(c), Income Tax Regs., the value of the
interest that it transferred to the city in partial satisfaction
of its rent obligation. The partnership appropriately treated
that transfer as the deemed sale of the eligible improvement.
See United States v. Gen. Shoe Corp., supra at 12-13. Because
the partnership recognized gain on that sale to the extent that
its depreciated basis was less than the rent credit, it properly
recaptured any depreciation previously claimed and there was no
duplication of deductions. The method used by the partnership in
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treating the matter as a deemed sale was used consistently
throughout the term of the lease. Accordingly, we find that the
partnership’s treatment of eligible improvements did not result
in an accounting method change.
VII. Whether Respondent Properly Proposed an Adjustment Under
Section 481(a) for Taxable Year 2000
Where there is a change of accounting method, section 481(a)
requires adjustments to prevent omissions or duplications and
allows the Commissioner to include in the adjustment amounts that
are attributable to taxable years for which assessment is barred
by the statute of limitations. Hamilton Indus., Inc. v.
Commissioner, 97 T.C. 120 (1991). As discussed above, because
there has been no change of accounting method in the instant
case, section 481(a) is not applicable.
VIII. Conclusion
On the basis of the foregoing, we conclude that the
partnership and the city intended that eligible improvements be
substitutes for rent; the leases in issue had economic substance
and were not shams designed merely to reduce taxes; the
partnership’s treatment of eligible improvements was a clear
reflection of income; the change from depreciating to deducting
the cost of the eligible improvements in the year of a rent
credit was not a change of accounting method; and the partnership
appropriately deducted the cost of an eligible improvement as a
rent expense in the year in which that eligible improvement was
- 34 -
credited against rent.
To reflect the foregoing,
Decisions will be entered
for petitioner.