Tom Talks Taxes - November 8, 2023

The truth about tax-free rental income using the Augusta Rule

I do a lot of tax planning and teach tax planning. It pains me when completely legitimate tax planning strategies are abused by lazy tax practitioners and social media gurus who often know little about tax (but can talk a good game).

One example of a tax provision with excellent planning opportunities that is often misrepresented is §280A(g), also known as the Augusta Rule:

Notwithstanding any other provision of this section or section 183, if a dwelling unit is used during the taxable year by the taxpayer as a residence and such dwelling unit is actually rented for less than 15 days during the taxable year, then (1) no deduction otherwise allowable under this chapter because of the rental use of such dwelling unit shall be allowed, and (2) the income derived from such use for the taxable year shall not be included in the gross income of such taxpayer under section 61.

Provision Overview

Here is the plain English translation of §280A(g): if a taxpayer rents their residence for less than 15 days per year, they can exclude the rental income from gross income, and the taxpayer gets no rental deductions.

On the other hand, if they rent their residence for 15 days or more, all of the rental income is included in gross income, but they can deduct their expenses.

When I lived in Maryland, I once used this provision with homeowners near the Naval Academy in Annapolis, Maryland. They made a lot of tax-free income by renting their residence during the Naval Academy graduation. As long as the total rental days for the tax year did not reach 15 days, the rent paid was tax-free.

Business Owner Tax Strategy

§280A(g) is a powerful tax planning strategy if a corporation’s shareholder can rent their residence to their corporation for a bona fide business purpose for less than 15 days per calendar year. The corporation can deduct the rent as a business expense, and the shareholder can exclude the rent paid from gross income under §280A(g).

Let me be crystal clear from the start: this strategy is only appropriate for some business owners, not all. Anytime taxpayers engage in a tax-advantaged transaction between themselves and a corporation they own, the IRS will scrutinize it; therefore, it should be limited to appropriate situations.

Good Application of the Strategy

Private Letter Ruling 8104117 demonstrates proper use of the business owner strategy. According to the facts presented in the ruling, an S corporation’s principal business was a television commercial production company that contracted with advertising agencies to produce television commercials. The S corporation rented the personal residences of shareholders and non-shareholders to film the commercials; the filming was usually confined to a specific portion of the home.

The IRS ruled that the payments to the shareholders were deductible as a §162(a) ordinary and necessary business expense provided that “the amount of such payment is customary in the industry (i.e.; is equal to the fair rental value of the residence for the use described herein).” The IRS also noted that the taxpayer can exclude the rental income if the residence was rented for less than 15 days.

Bad Application of the Strategy

In a recent case, the Tax Court considered a shareholder's abusive attempt to use §280A(g) to shelter business income from tax.

In Sinopoli v. Comm., T.C. Memo 2023-105, a corporation paid its three shareholders over $290,000 in rent over three years for rentals of their residences, and the shareholders excluded the rental payments from income under §280A(g).

The IRS was overly generous in the examination and allowed the corporation a $500 rent deduction for each meeting they could substantiate, which was one monthly meeting from January 2016 through September 2017. The Court allowed additional $500 deductions for 12 meetings the petitioner established with testimony; all others were not allowed.

Concerning the meetings, the Tax Court held that

Petitioners have not presented any written documentation such as minutes, agendas, or calendars showing that all the claimed meetings occurred during the years at issue to substantiate rent deductions of Planet. Furthermore, we find that petitioners' testimony was not credible as to the frequency of meetings during the years at issue. Their testimony was inconsistent and included testimony that petitioners did not recall the number of meetings that took place. Planet deducted rent expenses for three meetings per month, once at each residence. Petitioners have not established that meetings occurred at that frequency.

Concerning the rental amounts, the Tax Court held that

Petitioners have not established the reasonableness of the rent with documentation or credible testimony. Planet deducted $290,900 in rent that it purportedly paid to petitioners over less than three years. We agree with respondent that it seems that petitioners adopted a tax savings scheme to distribute Planet's earnings to petitioners through purported rent payments, claim rent deductions, and exclude the rent from their gross income relying on section 280A(g). While petitioners argue that the $500 rent determined by RA Burgess was not reasonable, we disagree and find to the contrary that $500 allowed per month is actually generous.

Doing §280A(g) Correctly

The private letter ruling and the Sinopoli case give insight into how business owners can correctly and ethically use §280A(g) as a tax planning strategy. When a shareholder wants to receive tax-free rental payments under §280A(g) from their corporation, follow these essential compliance rules:

1. The rental activity must have a bona fide business purpose to the corporation.

2. The corporation must execute a written agreement with the shareholder.

3. The agreement should state a reasonable, fair market value rate based on comparable rentals.

4. The corporation should retain documentation that substantiates the business use of the space during the rental period.

5. The corporation must pay the shareholder under the agreement.

6. The shareholder should track all fair market value rental days for their residence to ensure the total stays under 15 days for each calendar year.

Home Office Interaction

Much discussion has also been on whether the use of §280A(g) is compatible with claiming a business home office benefit. They are often entirely consistent; however, both strategies should be coordinated to avoid problems.

There are two potential complications in using these strategies in tandem:

1. Does the rental use violate the exclusive use requirement for a home office?

2. Does claiming a home office benefit increase the rental use beyond the 14 day limit?

As to the first issue, this is easy to avoid: the written agreement to rent the residence should explicitly exclude usage of the home office space.

Regarding the second issue, neither a direct home office deduction nor an accountable plan reimbursement of home office costs from a corporation is a rental activity. If a shareholder rents the home office space to the corporation, the §280A(g) exclusion would be unavailable due to the total rental use of the residence exceeding 14 days.

Business owners generally should not rent portions of their residence to their corporation for home office use. The use of the accountable plan is far superior to the home office rental because the corporation receives a deduction for the accountable plan expense while the shareholder does not have to recognize the income.

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