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Tax Research Problem: Determination of Taxable Income

Introduction

A leasing agreement guarantees a firm or an individual to use certain specific assets for which payment is required. This contractual relationship between the lessor and lessee can be for an indefinite period or periodic where there is an automatic renewal or certain agreed-upon fixed duration by the parties. However, most lease agreements are either periodic or fixed. Rental payments are also agreed on a certain basis that is suitable to the parties involved. Individuals and firms must pay taxes to the authorities. In taxable income determination, the issues surrounding leased property are encountered. This is further considered especially in situations where improvements of the property are done. Various case laws have helped to enhance the determination of gross income. This process involves the tax courts, supreme courts, revenue authorities, and other necessary authorities depending on the nature of the scenario in question. This paper addresses the facts, issues, and authorities involved in the given case study. It further gives recommendations aimed at determining the gross income of the lessor from the scenario given.

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Case Summary

William, the owner of a building, leases it to Lester’s Machine shop. Lester has made requests to William for the rewiring of the building to suit the new equipment for which Lester has made purchase plans. Though the wiring costs amount to $4,000, the value of the building would not increase since the only use of the connection is for the specialized equipment. None of the parties is willing to terminate the leasing agreement at this point. Therefore, both parties agree on a rent substitute of $1,000 and agree that Lester pays the costs of wiring.

Determination of the Facts

The given case scenario represents a fixed asset lease where the asset in consideration is a building. William, being the property owner, is the lessor in the agreement while Lester, being the one that enjoys the service use of the building, is the lessee. The lease agreement of the building has rent as the consideration. Although both William and Lester are not willing to terminate the lease agreement, the duration for the lease agreement is not stipulated (CCH Tax Law Editors, 2007).

Lester proposes improvements on the building through a wiring process. The intention of this is to cater to the specialized equipment that Lester has made purchase plans to acquire and use in the leasehold building. According to Dickinson (2008), leasehold improvements can be made by the lessor or lessee, although the lessor is always liable for those made by the lessee. This is because the lessor is the taxable party in leasehold properties and capitalizes the improvements for tax purposes (Pitt, 2009). An evident fact is that the improvements proposed are of a significant amount of $4,000 and do not add any value to the leasehold building. William does not wish to lose Lester as his lessee, so he proposes an agreement in which he forgoes the monthly rent of $1,000 on the condition that Lester pays for the improvements through the wiring process. Lester on the other hand is not willing to move. Hence there is no lease termination. Lester thus agrees to the proposal of William and so pays for the cost of wiring but does not pay the monthly rent the firm is expected to pay to William.

Issues Identified

The main issue identified in this scenario is whether the agreement between William the lessor and Lester the lessee forms a substitute for rent. William as the lessor is the one that proposes the agreement to forgo the monthly rent to maintain Lester as his lessee and has the condition that Lester pays the wiring cost. Lester on the other hand agrees to the proposal since it is not his intention to move.

Another issue evident in this scenario is whether the agreement forms the real intention of the parties in terms of the economic substance. According to CCH Tax Law Editors (2007), the intention of the parties in a leasehold agreement is determined based on the lease terms as well as the circumstances surrounding the agreement arrived at. Another issue in this scenario is the determination of the gross income of William. This is because the improvements in the scenario are not meant to add any extra value to the leasehold building. Further, the forgone rental income of $1,000 is lower than the improvement cost as well as the payment of the improvement costs by Lester who is ultimately the lessee.

Location of Applicable Authorities

The most applicable authorities in this scenario include the tax court, claims court, or the federal district court especially in the determination of the taxable income for the lessor and establishing the legal validity and implication of the agreement by the parties.

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Evaluation of the Authorities

The applicable authorities in this scenario handle cases involving deficiencies that amount to less than $100,000. These courts have jurisdiction on the issues pertinent in a lease agreement but work in conjunction with the revenue authorities. The tax court allows the taxpayer upon judgment to litigate without necessarily having to pay in advance. The claims and federal district courts require the taxpayer to pay the tax then file refund claims before the commencement of the lawsuit. Appeals to the court of appeal can be made from the claims and tax courts (CCH Tax Law Editors, 2007).

Analysis of Scenario

Substitution of rent: In consideration of the issue of whether the value of the improvements to the leasehold building forms rent, the tax court relies on the intention of the parties (Pitt, 2009). In this case, the lease has to be considered about the intention of the parties. At the time of the agreement, William forwent rent receipt on the condition that Lester pays for the improvements forming their intention. According to Dickinson (2008), a lease agreement in which the lessor accepts explicit and predetermined improvements to leased property by the lessee to substitute rent forms the intention of both parties.

Second, the tax court needs to analyze the actions of the two parties concerning the improvements. In this case, the action was taken by Lester to meet the cost of the improvements. This is respect to the treatment of the improvements cost against rent payable by the lessor and is consistent with the lease agreement

Analyzing the economic substance of the lease: In analyzing the economic substance of the agreement, the court needs to look at the effect of the agreement objectively in terms of benefits to the taxpayer as well as business motivation in terms of the other motivations to the taxpayer subjectively. In this case, the economic effect in terms of the benefits of William from the transaction was found to be nonexistent while the business motivation under the agreement was to help Lester derive satisfaction from the use of the building thus maintaining him as the lessee. William could not afford to lose Lester as the lessee while Lester did not find the need to move hence forming the basis of their agreement. Further, the court found out that this was backed by the fact that the improvements were not to increase the value of the building in any way but cater for the specialized equipment.

Determining the Gross Income of the Tax Payer

In this case, the gross income is based on the fact that the improvements were founded on the intentions of the parties although there was neither any intention of benefiting William in terms of tax payment nor did it add any extra-economic value to the building. In this regard, income is only recognized to the extent that it substitutes revenue to be taxed in the same way as the rental revenue that could have been received but was forgone. Hence the gross income of William is the value of the forgone rent which is $1,000.

Recommendations

The parties to the lease agreement need to enter into a formal written agreement to give a valid basis for their agreement. Further, in determining the gross income of the taxpayer, the consideration of the intent of the parties and the economic substance of the agreement is reviewed with clear adherence to the tax regulations. The gross income of William in this case should be the forgone rental income because although the improvements do not add any economic value to the building, they serve the function of maintaining the lessee thus forming value to the lessor (Pitt, 2009).

Conclusion

This paper has analyzed and reviewed the tax scenario given that involves the lease of a building. The facts of the case have been determined with the identification of the main issues as the substitution of the improvements for rent and the economic substance of the agreement. In addition, recommendations have been made about the lease agreement.

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Reference List

CCH Tax Law Editors. (2007). Federal tax compliance manual. New York: CCH Incorporated.

Dickinson, M. (2008). Federal income tax: codes and regulations. New York: McGraw Hill.

Pitt, A. (2009). Tax court addresses lease improvements as a substitute for rent. Web.

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StudyCorgi. (2022, March 16). Tax Research Problem: Determination of Taxable Income. Retrieved from https://studycorgi.com/tax-research-problem-determination-of-taxable-income/

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