If you are trading through a corporation or combination of legal entities that includes a corporation, you have the opportunity to obtain tax-free income by the proper utilization of a little-known tax code provision, Section 280A. This article will address the concept behind this strategy, the rules for its operation, and then conclude with several pitfalls to avoid.
First, the rules. They are simple, and so “taxpayer friendly” it is surprising. Section 280A(g) of the Internal Revenue Code states:
[I]f 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 . . . the income derived from such use for the taxable year shall not be included in the gross income of such taxpayer . . . *
Hence, under the plain language of this section, a taxpayer can (a) rent out his or her residence to someone else, including a corporation; (b) for fourteen days or less during a calendar year; and (c) not report the income received from the rental(s). To follow the logic to its ultimate tax conclusion, if the income is not includable in gross income, then taxes are not owed on that income.
It is also interesting to note what the code section does not say. It does not say that the rent paid by the renter (a corporation in our situation) is not deductible by the renter-corporation as an ordinary and necessary business expense. Nor does any other code section deny deductibility to the renter for the rent so paid. To the contrary, the general rule would be that reasonable rent paid by the corporation for space to conduct the corporate business is indeed a proper deduction.for the corporation.
So here is the strategy: Your corporation, which is recognized in the law as a separate legal entity and a separate taxpayer from you, is required by state law to hold at least one shareholder’s meeting and one directors’ meeting a year. That is the required minimum. It can hold more. Indeed, most corporations need to hold so-called “special meetings” of the Board of Directors on a frequent and periodic basis.
So the corporation needs space in which to hold such meetings. The location for special meetings of the Board is typically not specified in the By-Laws, and for good reason. The location needs to be “convenient,” and a fixed location might not always be convenient. The corporation could do what many corporations do, namely rent space at a local hotel for a board meeting. Were the corporation to do so, it could hold a directors’ meeting at the hotel, pay reasonable rent to the hotel (a figure typically determined by local market conditions), and the corporation could deduct the rent so paid as an ordinary and necessary business expense under § 162 of the Code.
Now Section 280A(g) comes into play. Instead of renting the meeting space at a local hotel or other facility, the corporation could rent your home for the meeting. Provided all the conditions of the Code were met, Section 280A(g) tells us that the rent received by you is not reportable and hence not taxable.
Tax-free income? Not even reportable? Yes, that’s exactly what is provided by Section 280A(g). But there are several caveats to take into account.
1. Do not violate the “less than fifteen day” rule. The “less than fifteen day” rule of the Code section contains no wiggle room. Fourteen days is “less than fifteen,” but fifteen is not less than fifteen. If you blow that rule by renting out the residence fifteen times or more during a year, the entire Code section does not apply. Then you are back to the general rules that otherwise govern such transactions: The entire income received (not just the portion above what was received for fourteen days) is reportable and taxable.
2. The rent paid must be reasonable. As with every other aspect of business expenses, then rent paid must meet the “ordinary and necessary” requirements of Section 162. The burden of proof as to the reasonableness rests on the taxpayer. To sustain that burden, the corporation should conduct a local market survey to determine what constitutes an appropriate, fair market value rent to be paid. For the survey to be fair and reasonable, the properties being compared should be comparable. Translation: The facilities that are being surveyed (e.g., local hotel meeting rooms) should be roughly comparable in appointments to the personal residence that will be rented. At the risk of sounding elitist, one who lives in a single-wide mobile home should not be surveying the rental cost of a room at the downtown Ritz-Carlton hotel. Those properties are not comparable.
Here is a suggested approach for determining the appropriate rent to be paid by the corporation to the homeowner:
a. Hold a special meeting of the corporate directors. The directors pass a resolution ordering the corporate president to conduct a survey of local facilities available for corporate directors meetings. The parameters of the search should be specified in the resolution. Typical parameters might be: a room for 4 attendees (or however many directors you have in your corporation), for a 2 hour meeting, with coffee, water and soft drink service to be refreshed after one hour, and available within a specified geographical area (the area where you live).
b. The corporate president then conducts the survey as directed. This will require talking to a representative in the “sales and catering” department, the “banquets” department, or whatever office within the hotel handles such meeting room arrangements. Ideally, ask the hotel representative to fax a bid proposal to you so you have the bid in writing. Failing that, the president needs to keep copious, detailed notes of where he called, who he spoke with, the date/time, the parameters of the room request, and the response received.
c. The president then analyzes the data received and prepares a recommendation to the Board on what rental value the corporation should be prepared to pay to hold its meetings. There is no set formula for analyzing the data. Do whatever is reasonable—throw out the high and low bids, average them all together, whatever makes sense.
d. The Board then holds another special meeting to receive the president’s report and recommendation. Assuming the Board accepts the president’s recommendation, the Board then adopts a corporate resolution that establishes the rent to be paid. It would be a good idea to attach the bid proposals received from the hotels and any notes made by the president to the corporate minutes that document this meeting as to how the decision was made what constitutes a fair and reasonable amount to pay for rental space.
As a side note, if the two special meetings of the corporate directors that were held as part of this process were held in your personal residence, the corporate resolution could conceivably provide for retroactive rent to be paid. In fact, it would be a good idea that the minutes of the prior meetings reflect that it is the Board’s intent that retroactive rent will be paid to the homeowner once the market survey results are known.
Let’s assume, for purposes of illustration, that the survey concludes that $500 per meeting is a fair and reasonable rent that reflects local market conditions. $500 per meeting times 14 meetings per year equals $7,000. That’s $7,000 of deductions to the corporation and $7,000 of tax-free income to the homeowner!
That’s not chump change. That’s real money, and real tax savings!
* Interestingly, the IRS has not issued any regulation for this Code section. That is unusual since most Code sections have regulations that construe the section and provide examples of how to apply the Code section.
** Each state’s corporation law specifies the frequency and number of required meetings. The Model Business Corporation Act, which has been adopted in some form in most states, requires a minimum of one annual meeting of shareholders and one annual meeting of the Board of Directors. Check your local state law to see whether additional meetings are required. Any requirement for more frequent meetings certainly should not present a problem to corporations that are pursuing the Section 280A strategy outlined in this article since those corporations are going to be holding frequent meetings.
*** The general rule is in Code § 61(a)(5), which states that “[e]xcept as otherwise provided in this subtitle, gross income means all income from whatever source derived including . . . rent.” Hence Section 280A(g) is an “except as otherwise provided” exception to the rule that would require inclusion in gross income of all rent received.
**** If you do live in such a personal residence, then you need to discount the rental values from the hotels to reflect the difference in the properties being compared. This is the same technique that a real estate appraiser uses to adjust for the appraisal values of different properties that are being compared. By way of example, if the hotel survey rendered a fair market rent of $500, then a discount of 50% (or whatever higher or lower discount factor was reasonable under your particular circumstances) would result in a fair market rental for your residence of $250.