New Rules for Construction Allowances Provided to Certain Lessees
Prior to 1997, issues frequently arose regarding the proper Federal income tax treatment of amounts provided by a lessor to a lessee, if those amounts were received by the lessee for the purpose of constructing property that would be used by the lessee pursuant to the lease. The inquiries made by the courts and the Internal Revenue Service in order to determine the tax treatment of such transactions were very fact-intensive and fact-specific and the entire area lent itself to controversy between the IRS and taxpayers. In some cases, such "construction allowances" were required to be included in the lessee's gross income; the lessee was then treated as the "owner" of the constructed property for tax purposes (regardless of where title lay for purposes of real estate law) and was entitled to claim depreciation deductions with respect to the property built with the proceeds of the construction allowance. In other cases, the lessee was not required to include the allowance in gross income, so that the lessor was treated as the owner of the property for tax purposes and claimed the depreciation deductions. In order to provide greater certainty and consistency, the Taxpayer Relief Act of 1997 added a new section 110 to the Internal Revenue Code; section 110 contains a safe harbor, which, if certain requirements are met, enables taxpayers to be certain that a construction allowance will not be considered income to the lessee.
Section 110 applies only in limited cases -- i.e., in the case of a lease of retail space for a term of 15 years or less entered into after August 5, 1997, and then only if the construction allowance is expended for the construction or improvement of real property for use in the lessee's trade or business at the retail space. If section 110 does apply, amounts received by the lessee in cash or as a rent reduction are not included in the lessee's income and the lessor is treated for tax purposes as the "owner" of the improvements constructed by the lessee with the proceeds of the construction allowance. If section 110 does not apply to a construction allowance, its tax treatment continues to be governed by prior law.
The Treasury Department recently issued final regulations under section 110, to be effective October 5, 2000. Although the final regulations do not provide for a formal election under which they may be applied retroactively, taxpayers who comply with the substantive rules set forth in the regulations for leases entered into after August 5, 1997, and prior to the effective date of the regulations will be treated as meeting the requirements of section 110.
Under the final regulations, the rules of section 110 will apply to any "qualified lessee construction allowance," that is, any amount received in cash (or treated as a rent reduction) by a lessee from a lessor under a short-term lease(1) of retail space, provided that certain "purpose" and "expenditure" requirements are met. The final regulations flesh out the purpose and expenditure requirements, contain additional guidance regarding the scope of section 110, and impose some filing requirements.
Purpose Requirement
The purpose requirement mandates that amounts be received by the lessee from the lessor "for the purpose of ... constructing or improving ... real property for use in [the] lessee's trade or business" at the retail space leased by the lessee from the lessor. The final regulations add that, in order to satisfy this purpose requirement, it is necessary to express in the lease agreement that the construction allowance is for the purpose of constructing or improving qualified long-term real property for use in the lessee's trade or business at the retail space. However, an ancillary agreement executed contemporane-ously with the payment of a construction allowance, whether executed with the lease or during the term of the lease, is considered a provision of the lease agreement for this purpose.
Expenditure Requirement
The expenditure requirement limits the benefits of section 110 to the "amount expended by the lessee for ... construction or improvement." The final regulations make this requirement a bit more stringent by adding a temporal aspect -- the lessee must expend the money received from the lessor (or an amount equal to the amount treated as a rent reduction) on construction within the taxable year during which the money is received, or within 8-1/2 months thereafter. Money expended by the lessee during the taxable year prior to the year in which the construction allowance is received also meets the expenditure requirement, provided the lessee has not depreciated the expenditures.
However, the final regulations also liberalize the expenditure requirement by negating any inference that "tracing" of funds is required. Any expenditures of the lessee for qualified property made during the period described above may be treated as being made first from the lessee's construction allowance. However, the lessee should maintain accurate records of the amount of the qualified lessee construction allowance received and the expenditures made for qualified property.
Other Substantive Rules
Section 110 does not apply unless the property is used by the lessee "in its trade or business of selling tangible personal property or services to the general public." The regulations clarify that offices for hair stylists, tailors, shoe repairmen, doctors, lawyers, accountants, insurance agents, financial advisors, stock brokers, securities dealers (including dealers who sell securities out of inventory), and bankers are all included in this definition of retail space. A taxpayer is considered to be selling to the general public if the taxpayer's products or services for sale are made available to everyone, even though only certain customers or clients are targeted. The term "retail space" includes not only the space where the retail sales are made, but also space where activities supporting the retail activity are performed (such as an administrative office, a storage area, and an employee lounge).
Filing Requirements
The final regulations require qualified lessee construction allowance information to be furnished by the lessor and the lessee to the IRS, and describe the time and manner for providing that information to the IRS. A lessor or lessee that fails to furnish the required information may be subject to a penalty.
If you have any questions on these or related matters, please call Elliot Pisem (903-8777), Carolyn Joy Lee (903-8761), or Lary Wolf (903-8719), all of whom work extensively in this area.
FOOTNOTES: _______________________
1. A short-term lease is a lease (or other agreement for occupancy or use) of retail space for 15 years or less. The Code provides some rules for determining when renewal options will be considered part of the lease term. In particular, any option to renew at fair market value, determined at the time of renewal, is not taken into account for purposes of determining the lease term. Despite commentators' requests, the final regulations do not provide any additional guidance on whether certain common renewal options will be considered to be at fair market value.