Leases Between Single Member LLC
and the Single Member
Tax Adviser, October 2006
by Albert B. Ellentuck

Summary: The article presents a discussion of a case study on leasing property to a limited liability company (LLC) in the U.S., adapted from the book "PPC's Guide to Limited Liability Companies," 11th Edition, by Michael E. Mares, Sara S. McMurian, Stephen E. Pascarella II and Gregory A. Porcaro.

Excerpt from Article:

Rather than contributing or selling property, a limited liability company (LLC) member may wish to retain property ownership, while making it available for the LLC's use or benefit. Leases of property to LLCs and other transactions in which a member retains ownership--such as a member's pledge of separately owned assets to obtain or secure LLC debt--are regarded as transactions between an LLC and a nonmember (subject, of course, to "related-party transaction considerations); see Regs. Sec. 1.707-1(a).

A lease agreement involving related parties can be a vehicle for shifting income and deductions, as well as a disguise for other transactions between the lessee and a related lessor. For this reason, Sec. 267 provides for careful matching of income and deductions between related parties. As with other expenses paid to a cash-basis member, an accrual-basis LLC cannot deduct rent expense owed to a cash-basis member until the expenses are paid and included in the member's income; see Sec. 267(a)(2). This rule also applies to payments from an accrual-basis LLC to any cash-basis taxpayer who indirectly holds an interest in the LLC, or to any cash-basis taxpayer related to a member.

In addition, related parties are presumed not to be dealing at arm's length and, accordingly, are subject to additional scrutiny by the IRS. For example, in United Builders Supply, Inc., DC MS, 1/11/78, rents were found to be excessive and unreasonable in amount; consequently, a portion of the lessee's rent deduction was disallowed. When a deduction for unreasonable rent is disallowed, the Service is not obligated to reduce the rent income of the related lessor, making this a potentially disastrous situation. If a question exists as to the reasonableness of the rent, the parties may consider adding a clause to the agreement (before entering into it) providing for repayment by the lessor of any disallowed rents. However, this may create a red flag that the parties believed the rent charged might be unreasonable.

Practice tip: The deductibility of rents between related parties is essentially determined by the facts and circumstances; thus, it is wise for the member and the LLC to build evidence at the onset of the lease to support the reasonableness of the rent called for in the lease agreement. This could include documentation of the commercial practices and the rents paid for similar properties in the area at the time the lease is entered into. Additionally, there should be a written lease with the usual and customary lease provisions. The validity of the lease may also be enhanced by evidence that both parties complied with its terms and that rents were paid on time.…