Certain leaseback transactions invite IRS scrutiny.

Giving or selling income-producing property to children provides opportunities for family tax savings, but only if the transactions can withstand Internal Revenue Service scrutiny. Like family loans and loan guarantees, the IRS almost always will challenge the substance of such transactions. This article examines gift-leaseback and sale-leaseback transactions among family members and offers suggestions to avoid IRS attacks.

GIFT-LEASEBACK TRANSACTIONS

A gift-leaseback of income-producing property to children usually is structured to help donors

* Shift high-bracket income to lowbracket children over 13 years of age.

* Continue to manage a property and collect rents as the children's guardian.

* Deduct rent payments made to themselves as the children's guardian.

* Create a source of funds from the rental income to pay for a variety of items for the children, such as education.

* Immunize the gift properties from possible estate tax through lifetime transfers.

A typical gift-leaseback arrangement structured with these objectives in mind might go like this: Jason Smith purchased a building several years ago for his business at a cost of $487,500. The building's depreciated basis is $437,500 with an annual depreciation deduction of $12,500 (39-year life, no salvage value, straight-line depreciation). Assuming a fair rental value for the building of $20,000 annually, Smith can get a larger deduction by transferring the building to a trust and then leasing it from the trust at the fair rental value ($20,000 rent deduction versus $12,500 depreciation deduction).

Smith structures the trust arrangement so the trust period is 12 years; the trust's net income is payable to his daughter, Mary, who is over 13 years of age and whom Smith is not legally obligated to support. The trust instrument requires the trustee to build up a depreciation reserve at the rate of $12,500 per year; the building will go to Smith's son, Albert, when the trust terminates at the end of 12 years.

What has Smith accomplished? The $20,000 of rent will be divided between the trust and Smith's daughter. The trust will escrow $12,500 each year as a depreciation reserve and thus will pay no tax on this amount. Mary will receive and pay taxes on the remaining $7,500 each year (a total of $90,000 over the 12-year period) - less than her father would have paid in his higher tax bracket. At the end of 12 years, Smith's son will receive the building with an adjusted basis of $287,500 ($437,500 less depreciation of $12,500 for each of 12 years). Albert also will receive the $150,000 built up as a depreciation reserve (on which no income taxes have been paid). All of these tax benefits are realized while keeping the property in the immediate family.

IRS CHALLENGE

The IRS generally uses one or more arguments to challenge family gift-leaseback transactions such as the Smith's.

* The donor maintains an equity interest in the property.

* The transaction lacks a business purpose or defies economic reality.

* The trustee is not independent.

* The donor fails to transfer a sufficient property interest.

If the courts uphold an IRS challenge to Jason Smith's gift-leaseback transaction, Smith would lose the annual rental deduction and thus may have to increase his taxable income by $20,000. Denial of the rental deduction does not automatically lead to Smith's including the trust's income in his because different standards determine eligibility for the deduction. Smith's daughter will either pay tax on the $7,500 the trust distributes to her if the arrangement is upheld, or will treat it as a gift.

To ensure Smith's intentions are realized, he obviously should be prepared to counter each of the IRS's expected arguments. Fortunately, except for the business purpose test, the courts have been fairly consistent in showing what will and will not counter each argument.

Equity interest. The donor must not hold title to the property or retain a reversionary interest in it. The courts have disallowed the rental deduction when a donor transferred the property to the trust only for a period of years but have allowed the deduction when the property did not revert to the donor.

Business purpose or economic reality. The transaction must serve a business purpose and economic reality must be evidenced by a written leaseback agreement that requires payment of a reasonable rent. The courts have differed in their application of the business purpose test. The Fourth and Fifth Circuit Courts of Appeal require a business purpose or economic reality for the entire gift-leaseback transaction. The Tax Court and the other circuits first determine whether the gift is a valid transfer and then apply the business purpose test to the leaseback. Because the gift portion of the gift-leaseback transaction rarely has a business purpose,.the integrated approach used by the, Fourth and Fifth Circuits-appears to preclude the use of a gift-leaseback transaction.

A three-party gift-leaseback transaction, however, may work in all circuits. The IRS has said it will not challenge gift-leasebacks if the lessee is not the grantor but a separate taxable entity. Thus, a gift-leaseback involving a transferee-individual, a transferee-trust and a lessee-C corporation should withstand IRS challenge.

Trustee independence. The pivotal factor used by the courts in determining the deductibility of rents has been the trustee's independence (or as phrased by the Tax Court, the control retained by the donor). The courts have denied a rental deduction when the donor retained control of the property by serving as trustee but have allowed the deduction when the trustee was the donor's attorney, spouse, parent, accountant, acquaintance serving as an uncompensated trustee or financial institution. The deduction generally has been upheld when the trustee negotiated the lease and acted primarily in the interest of the beneficiaries. Even when property reverted to the donors, the Tax Court upheld the rental deductions because the independent trustee negotiated a series of leases on the trust property and was given the power to "sell, lease, exchange or otherwise dispose of the property."

Transfer of sufficient property interest. Ensuring the transfer of a property interest sufficient to justify the rental deduction has been met partly by the donor's selection of an independent trustee. Other factors the courts consider in determining the sufficiency of the property interest transferred include

* The duration of the transfer (the longer the better).

* The controls retained by the donor (the fewer the better).

* The use of the gift property for the donor's benefit (the less use the better).

SALE-LEASEBACK TRANSACTIONS

Sale-leaseback transactions involving family members may accomplish many of the same objectives as gift-leaseback transactions. Unfortunately, they also attract the same degree of scrutiny from the IRS and the courts.

In Hudspeth, the Ninth Circuit's decision illustrates how the courts view such transactions. Mr. and Mrs. Hudspeth owned 1,500 acres of federally irrigated land. Until notified by authorities, they were unaware federal law limited the amount of such land any one person could own to 160 acres. No rules of attribution were incorporated in the law, and thus each family member could own 160 acres.

Lacking sufficient funds to pay gift taxes, the Hudspeths decided to sell rather than give the acreage to their sons to comply with the law. The transaction was structured to deed 320 acres to each of the Hudspeths' two married children and their wives and 160 acres to their unmarried son in exchange for nonnegotiable notes and purchase money mortgages. The deal also included a leaseback to the Hudspeths. Their lease payments, plus contemplated annual gifts to the sons and their wives (within the allowable gift tax exclusions), would provide sufficient funds to pay the notes.

The court held that the Hudspeths' sales were legitimate and, had the children not paid, the parents could have foreclosed. The court believed the children were obligated to make the mortgage payments regardless of whether the parents made their annual cash gifts. Nonetheless, because the annual gifts were merely an exchange of checks between parents and children, they did not support an interest deduction. Thus, the court allowed the children an interest deduction only for that part of the interest paid by the rents they received. The court did not explain its rationale for this holding, but it seems that if the original transaction had been a legitimate sale, the gifts would have been genuine and the children would have been entitled to deduct the interest. Such inconsistencies in court holdings only add to the uncertainty taxpayers face when they engage in sale-leaseback transactions involving family members.

HEAVY TAXPAYER BURDEN

The Tax Court decision in Maxwell Estate further illustrates the skepticism with which sale-leasebacks involving family members are viewed. The decedent, Mrs. Maxwell, purportedly sold her personal residence to her only living child and his wife for $270,000. The proceeds consisted of a $250,000 mortgage and Mrs. Maxwell's forgiveness of the remaining $20,000 as a gift to her son and his wife. At the sale date, Mrs. Maxwell also signed a five-year lease with monthly rent payments approximately equal to, but short of, the property expenses. No evidence was submitted on whether the rent payments constituted fair market value.

Two days after the purported sale, Mrs. Maxwell changed her will so the mortgage indebtedness would be canceled at her death. A year later, she forgave an additional $20,000 of the mortgage principal balance and issued a new mortgage note at the reduced rate. Approximately 10 months later (in the next tax year), she forgave another $20,000 but did not issue a new mortgage. Beginning one month after the initial sale, monthly interest payments were made on the note. Various administrative tasks relative to the lease arrangement, such as retitling insurance on the property, were not performed.

The Tax Court held the substance of this transaction dictated the full value of the house be included in the decedent's estate under Internal Revenue Code section 2036(a). In the court's view, the decedent made a transfer to her son and his wife with the understanding - at least implied - that she would reside in her home until death, the sale was not a bona fide sale for adequate and full consideration and the lease was nothing more than an attempt to add color to the characterization of the transaction as a bona fide sale.

The Tax Court further emphasized the burden of disproving the existence of any implied agreement or understanding was on the petitioner, and that burden was greater because an intra-family arrangement was involved. The court noted that the understanding between family members that a purported obligation will not be honored does not have to be legally enforceable. If the parties adhere to the understanding the transfer is not a bona fide sale, the sale-leaseback lacks substance.

BUSINESS-PURPOSE-ONLY ESCAPE

VALVE

Establishing a business purpose for a sale-leaseback among related parties may salvage the transaction. A good example of taxpayers successfully using this strategy is found in the Tax Court case of Carroll. The seller-lessee, who operated a construction company as a sole proprietorship, wanted to increase the company's performance bonding capacity. The seller-lessee formed a corporation that purchased the proprietorship's construction equipment and leased it back to the proprietorship. The transaction was expected to reduce federal income taxes by more than $70,000 per year, which would improve the corporation's working capital position and thereby help it obtain an increased debt ceiling. The IRS argued the sale-leaseback was a sham and denied the proprietorship's rental deductions. The parties agreed the rental under the leaseback was reasonable.

The Tax Court found there was a legitimate business purpose for the sale-leaseback: to improve the seller-lessee's bonding capacity. In addition, it found these factors significant:

* Throughout the lease term, the proprietorship made substantial rental payments to the corporation, resulting in meaningful profits on which the corporation paid substantial taxes.

* The profits realized by the corporation were used to purchase additional equipment.

* All relevant third parties - the bank holding a security interest in the equipment and the bonding company - were notified of the sale and given an opportunity to protect their interests.

* The proprietorship did not retain a direct interest in the assets.

Given these circumstances, the court concluded the tax savings involved in the transaction did not make it a sham. The sale-leaseback had a legitimate business purpose and thus should be recognized for tax purposes.

WITHSTANDING THE CHALLENGE

Gift-leaseback and sale-leaseback transactions may not always be characterized as sham transactions but almost always will be challenged by the IRS. CPAs must be aware of the nature of these challenges to place their clients in the best positions to withstand them.

EXECUTIVE SUMMARY

* THE INTERNAL REVENUE SERVICE almost always will challenge the substance of transactions in which income-producing property is given or sold to other family members and leased back. Transactions that withstand the challenge offer the potential for tax savings. * A TYPICAL GIFT-LEASEBACK transaction is structured to shift income to low-bracket family members, allow the donor to manage the property and collect rents as the recipient's guardian, permit the donor to deduct those rent payments, generate funds for the recipient and immunize the gift from possible estate taxes. * FAMILY GIFT-LEASEBACK transactions frequently are subject to IRS scrutiny because the donor maintains an equity interest in the property, the transaction lacks a business purpose or defies economics reality, the trustee is not independent or the door fails to transfer a sufficient property interest to justify a deduction. * SALE-LEASEBACKS BETWEEN family members offer many of the same benefits and suffer many of the same IRS attacks. The taxpayer bears the burden of proving the transfer is a bona fide sale and has a business purpose. * TO HELP CLIENTS WITHSTAND IRS challenges, CPAs should be aware of court cases that indicate how taxpayers can successfully refute charges that transactions lack economics substance.

LEE G. KNIGHT, PhD, is E.H. Sherman Professor of Accountancy at Troy State University, Troy, Alabama. RAY A. KNIGHT, CPA, JD, is an independent consultant in Troy.