IRS Gives Taxpayers a Mulligan on Improper Application of Master’s Rule

In light of the recent decision in the Sinopoli v. IRS Commissioner US Tax Court Case, the application and interpretation of the Master’s rule has come under the spotlight. The Master’s rule allows homeowners to exclude income from federal tax for properties rented out for 14 days or less in a tax year.

The case verdict, in favor of the Internal Revenue Service, sheds new light on the intricacies and potential pitfalls of the rule, especially in the age of Airbnb and other short-term rental platforms.

If the rule’s name sounds familiar, it is because it got its name from the famous Augusta National Golf Club in Georgia. During the tournament, there would be a high demand for dwellings which would be difficult to meet without the participation of local homeowners. Given the limited nature of the event, the local homeowners argued (and IRS agreed) they should not be viewed as engaged in a trade or business. Although the rule is rooted in a local event, it applies to all taxpayers who meet the 14-day or less requirement without regard to the amount.

In the era of Airbnb, this rule turned out to be a boon for some taxpayers renting out their homes. Other taxpayers went even further in exercising their creativity, as recently demonstrated in the Sinopoli v. IRS Commissioner US Tax Court Case.¹

In this case, the US Court ruled in favor of the Internal Revenue Service, which disallowed most of the taxpayers’ rent and advertising expenses claimed on the taxpayer’s S corporation books.

The taxpayers may have thought they struck tax gold when they decided to rent their homes to the corporation, claim the rental expense as a deduction at the corporate level while excluding the rental income from their gross income under IRC §280A(g) (exclusion under Master’s rule applicable to rentals of 14 days or less).

Over three years, the taxpayers deducted over $290,000 in rental expenses at the corporation level while excluding all of the income on the receiving end under the 14-day rule.

Exploiting this type of ‘tax loophole’ is often touted across social media channels as clickbait. What is being left out turns out to be crucial. In the case described above, the arrangement was set as a related-party transaction (the shareholders and their corporations are considered related parties, very much like a transaction between a father and a son).

Related-party transactions are inherently suspected of being self-serving, have an increased risk of expense disallowance, and carry the burden of meeting the ‘arms-length requirements’ to fulfill their purpose. And to add another layer, auditing related-party arrangements has been an IRS all-time favorite.

Generally, a corporation can deduct an expense if it is necessary and ordinary. According to the IRS, an ordinary expense is one that is common and accepted in the industry. To be necessary, an expense should be helpful and appropriate for the trade or business.² Facts and circumstances are considered when evaluating whether an expense is ordinary and necessary. No matter the case, the burden of proof of substantiation lies with the taxpayers.

In this case, the taxpayers failed the reasonableness test inherent to related-party transactions. The IRS successfully demonstrated the rent price in the taxpayers’ living area was a fraction of what was claimed. The taxpayers also failed to substantiate through meeting minutes, agendas, etc., that the meetings for which rent expense was claimed even took place or that business was conducted during the meetings.

Concepts such as reasonableness, ordinary and necessary, substantiation, and intent are overarching Internal Revenue Code themes that become the starting point in evaluating the merits of any case brought into US Tax Court regardless of the ‘creativity’ some taxpayers exercise when interpreting various sections of the Code.

IRS interest and win in this Court Case is relevant as it may signal IRS’ potential intent to change the 14-day rule by applying some limits or even repealing it altogether.

Marcum will work closely with you to analyze the merits/pitfalls of various tax strategies and keep you informed of any new tax law developments and opportunities. If you have any questions about what these developments may mean for you or your business, please get in touch with Marcum’s Private Client Services Team.

Sources

1. Gary J. Sinopoli, Jr. and Melissa M. Sinopoli, Et Al., v. Commissioner of Internal Revenue, Docket Nos. 10838-20 and 10840-20
2. IRS Publication 535 “Business Expense”.