Owning Assets That You Lease to Your Business Can Make Sense
It is not uncommon for the owners or shareholders in a racquet sports business to own the real estate or other assets personally, then rent them to their operation. In fact, it is often a smart move from both a tax and a business standpoint.
Does your business need an infusion of cash? Are you, the owner or principal shareholder, reluctant to invest additional money? Or, are the tax benefits from the business wasted because of the operation’s low or nonexistent profits — and its low tax bracket?
The often-neglected and little understood “sale-leaseback” can help in all of these situations. Selling the tennis operation’s real estate or its equipment to an outside purchaser, who will then lease it back to the business, is a viable financing tool. Many business owners have reaped tax benefits from property that they own and lease to their businesses.
Be aware, however, that increasingly, the tax benefit can turn into a tax trap for the unwary, as the IRS is more frequently challenging both the validity and the tax treatment of the losses often generated with self-rental.
Business owners today have become more creative in terms of seeking alternatives for capital funding. Converting real estate or equipment assets to cash is a time-honored technique. A sale-leaseback frees up capital for expansion or other purposes, including retiring outstanding debt. Improving the operation to aid efficiency, increase sales, or expand are valid rewards that can result from a sale-leaseback.
Converting “non-earning” assets into investment capital can help enhance your business’s financial position as well as its profitability. A sale-leaseback, if properly structured, can improve the debt-to-equity ratio and reduce interest and depreciation expenses.
Suppose, however, that the purchaser of the tennis operation’s real estate is not an outsider but its owner or principal shareholder? Suddenly, those non-performing assets of the business begin providing income and tax benefits to the buyer.
Renting to Yourself
When the tennis operation’s owner purchases the property of his or her business in a properly structured, arm’s-length transaction, the tax benefits usually are also transferred. What may have been a largely wasted depreciation deduction for the business becomes an income-reducing benefit for the new owner. Also helping reduce the owner’s personal taxable income are the interest payments for the funds borrowed to make the purchase.
Offsetting the deductions, which may be far more valuable to the owner than to the business itself, is the income from the payments made under the terms of that lease. Rarely do the required “fair market” lease payments made by the business offset the expenses of owning, repairing, and maintaining that property. In other words, a loss is available to offset the owner’s income from other sources.
Unfortunately, under our tax laws, specifically Section 469, income from rental real estate generally is considered passive activity income, regardless of the owner’s level of involvement in managing the property. Tax rules state that a taxpayer can use losses from a passive activity only to offset passive activity income. In other words, passive losses cannot shelter other income such as profits, salaries, wages, or portfolio income such as interest, dividend, or annuity income.
A loophole built into the rules states that rental realty income is not passive activity income if the property is rented for use in a trade or business in which the taxpayer materially participates. This prevents taxpayers with passive activity losses from artificially creating passive activity income to absorb the losses. In order to be eligible for this exception, the property’s owner or his or her spouse must own at least a 10 percent interest in the activity throughout the year.
An individual may, for example, meet the active participation requirement if he participates in management decisions (such as approving tenants, deciding on rental terms, approving expenditures, etc.) or arranges for others to provide these services in a significant sense. The active participation requirement applies for the year in which the loss arose, as well as the year in which it was allowed under the $25,000 allowance rule. Under this exception, up to $25,000 of passive losses and the deduction equivalent of tax credits that are attributable to rental real estate can be used to offset non-passive sources such as interest, dividends, and salaries.
When the operator or principal shareholders of a facility or business own either the building or the operation’s other assets, the business pays — and deducts — lease payments. A tennis business that has a low tax bill or is unprofitable exchanges depreciable equipment or its building for badly-needed capital and immediate deductions for the lease payments that it is required to make.
The new owner of the property, whether it is the business’s owner, chief shareholder, or other party, will receive periodic lease payments. Thus, with one transaction, the owner has found a way to get money from the business without the double-tax bite imposed on dividends or fear of the excessive compensation penalties the IRS levies in situations where an operation’s profits may be paid out as compensation.
Lease payments are, of course, taxable income to the recipient. Fortunately, tax deductions offset much of that income before it reaches the recipient’s bottom-line taxable income.
Depreciation write-offs or deductions cost the owner of those assets nothing out-of-pocket. Somewhere down the road, those depreciation deductions will have to be paid back or recovered, usually as ordinary income, but that is at some distant date.
The owner or owners of the business’s equipment and assets also are entitled to deductions for the expense of borrowing the money used to purchase them. Additional tax deductions such as management fees, maintenance, insurance and the like, further reduce the tax bill on lease payments received from the tennis operation.
The Bottom Line
With a sale-leaseback you, the owner, are receiving a steady stream of lease payments that, unlike dividends, are tax deductible by the business. As the owner of those assets or equipment, you are entitled to take advantage of all of the tax deductions associated with it.
Except where the assets of the tennis business are already subject to restrictions imposed by lenders or other investors, you, the owner of those assets, are enjoying tax write-offs that might not fully benefit the business entity with its small or nonexistent profits and correspondingly lower tax bracket.
The sale-leaseback of your business’s assets, equipment, or building can cure a number of problems facing you and the business. But keep in mind that the complexity of the tax rules, the requirement that all transactions be conducted at “arm’s length,” have a bona-fide economic purpose rather than mere tax avoidance, and be properly structured as both a “sale” and subsequent “lease,” require professional assistance.
See all articles by Mark E. Battersby
About the Author
Mark E. Battersby is a tax advisor and author in Ardmore, Pa.