Wisconsin trucker skids into "self-rental" rule
It’s common for taxpayers to rent things to their businesses. Owners of C corporations often find rentals a tax-efficient way to pull cash out of a business and get a rent deduction, instead of paying non-deductible dividends. Sometimes an owner of a multi-owner business will also provide the real estate via rental. It usually works fine, but a Wisconsin trucking operator last week learned in Tax Court of a tax trap that sometimes lurks in self-rental.
The taxpayer ran his Wisconsin trucking business as a C corporation -- a corporation that pays its own taxes. If a C corporation pays dividends, they are taxable to the owner and non-deductible to the corporation -- so corporate income is taxed both when it is earned and when it is distributed.
The trucking company owned no trucks. Instead it leased them from an S corporation owned by the taxpayer, and also from the taxpayer personally. An S corporation pays no taxes; its income is instead taxed directly on the shareholder’s returns, and distributions of taxable income are not taxed again. In short, the rental income showed up on the owner's 1040, and the C corporation took a deduction while getting cash to its owner.
So far, so good. Unfortunately the "passive loss" rules add another wrinkle. The passive loss rules were enacted largely to shut down the leasing tax shelters of the 1980s. They say that rental losses are normally "passive," deductible only to the extent of "passive" income. The taxwriters of the day feared that business owners would get around these rules by renting items to their own business to artificially create passive income that would allow them to continue to deduct passive losses. Their response was the "self-leasing" rule.
The self-leasing rule says that if you have income from leasing an "item" to a non-passive business that you own, that income is non-passive -- but self-rental losses are still passive. That means self-leasing income doesn't help you deduct passive losses.
The Wisconsin taxpayer had taxable income on the trucks he leased through his S corporation, but losses on the trucks leased personally. The IRS examined his return and told him he couldn't deduct the self-rental loss against the self-rental income. The Tax Court last week upheld the IRS. They also told the taxpayer that he was lucky the IRS didn't make things even worse:
…we conclude that each individual tractor and each trailer was a separate “item of property” within the meaning of section 1.469-2(f)(6), Income Tax Regs. However, because respondent has not contested petitioners’ netting of gains and losses within TRI [the S corporation], only TRI’s net income is recharacterized as nonpassive income.
In other words, the court said the IRS could require the taxpayer to break out the income tractor-by-tractor and disallow the losses on each lease generating a tax loss.
The case gives us two important lessons:
1. Rental income from items rented to your non-passive business doesn't help you deduct other "passive" losses.
2. If you rent multiple items to your business, you should make sure each item generates taxable income. This could affect how you structure your leases and what depreciation decisions -- like bonus depreciation -- you take.
These rules are complex, so be sure to get your tax advisor involved early.