January 2002

John McGill’s TAX Q&A

Q I am planning to take advantage of rising vacancy rates in my area to lease new office space that will provide a larger facility. In order to receive the best lease rates and terms, I plan to enter into a 20-year lease term. The landlord has promised me a total of $80,000 in tenant improvement allowances to help offset the build-out costs. My accountant has told me that this amount must be reported by me as income. How can this be if I am simply investing this money in leasehold improvements that will belong to the landlord at the end of the lease term?

AThe Internal Revenue Service recently issued final regulations under Section 110 of the tax law, setting forth the rules under which tenant improvement allowances would qualify as tax-free payments. Under the new rule, both you and the landlord will be required to report this transaction for federal income-tax purposes.

Under the new regulations, tenants are allowed to exclude from their income amounts received for tenant improvements or other construction allowances actually used to construct leasehold improvements to their space that will revert to the landlord at the end of the lease term, provided that the lease term is for 15 years or less.

If you follow through with your plans to sign a longer-term, 20-year lease, the amounts received would not qualify for tax-free treatment under the IRS regulations. Accordingly, you would be wise to reduce the lease term to 15 years and negotiate a five-year option to renew, so you can qualify for tax-free treatment under these IRS regulations.

Q My practice’s tax return was selected recently for an Internal Revenue Service audit. The IRS agent who performed the audit is disallowing certain advertising and employee training costs, saying that these must be capitalized and deducted over a longer-term period, since they will provide benefits during future years. My accountant disagrees with the auditor’s assessment. Who is correct?

A Your accountant. The IRS has become more aggressive in recent years in trying to force doctors and other small businesses into deducting expenses such as these over a longer time period. However, the courts have universally agreed after legal challenges that while some advertising and employee training costs may provide a benefit period beyond the current year, all amounts paid for these expenses are nevertheless fully deductible in the year paid. sMr. McGill, MBA, CPA, JD, is a tax attorney with McGill and Hassan, P.A., a legal firm in Charlotte, N.C., that specializes in financial issues. He formerly worked with the Office of Chief Counsel, the legal branch of the Internal Revenue Service in Washington, D.C.