Tax court ruling on 'Masters' or 'Augusta' rule offers cautionary tale

The owners of an S-corporation drastically overshot the green in their use of the "Masters" deduction, according to a recent tax court decision providing guidance to financial advisors.

As long as they don't use their residence as their primary place of business, homeowners can exclude up to 14 days' worth of rent payments from their income in a given year through an exemption in the tax code named for the PGA Tour event played each year in Augusta, Georgia — where people often take on temporary tenants during the major golf tournament. Tax professionals refer to the Section 280A(g) exemption as the "Masters" or "Augusta" rule.

Three households whose joint S-corporation owned franchise locations of fitness centers in Mississippi claimed combined deductions of $290,000 for rent that the company paid them for meetings held in their respective homes during a three-year span, according to the Aug. 14 decision in the tax court case, Sinopoli v. Commissioner. An IRS revenue agent correctly slashed their deduction to $16,500 when correcting for reasonable rent rates and a lack of documentation for many of the meetings, according to the decision.

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The case offers a helpful reminder to advisors about the tax exemption, said Alexis Gallati, an enrolled agent who is the founder of Knoxville, Tennessee-based Cerebral Tax Advisors. Clients need to keep records displaying the use of their residence and how they charged "equivalent rental rates in [the] area" — rather than the "very aggressive" ones claimed by the households in the payments from their S-corporation in this case, she said.

"You obviously have to do fair rental rates," Gallati said. "You have to make sure to do proper research and substantiate where you came up with your rental number as well."

Since the taxpayers were using their homes for meetings about their fitness centers, they should have documented "the business purpose" by keeping minutes of their discussions and other paper trails, she said. 

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Agendas or calendars could have added to the evidence as well, Senior Judge Joseph Robert Goeke noted in the decision. The IRS revenue agent's calculation of a rent of $500 per meeting was "actually generous," considering that they didn't take up the whole homes for an entire day, Goeke wrote. While the S-corporation paid the households between $3,000 to $4,000 per meeting based on area rental rates of $1.83 per square foot against the common areas of their homes, the IRS agent found those prices unreasonable, according to the judge. 

Goeke agreed with the agent's finding "that it seems that petitioners adopted a tax savings scheme to distribute [the S-corporation's] earnings to petitioners through purported rent payments, claim rent deductions and exclude the rent from their gross income," he wrote.

"Petitioners have not presented any written documentation such as minutes, agendas, or calendars showing that all the claimed meetings occurred during the years at issue to substantiate rent deductions of [the company]," Goeke said. "Furthermore, we find that petitioners' testimony was not credible as to the frequency of meetings during the years at issue. Their testimony was inconsistent and included testimony that petitioners did not recall the number of meetings that took place. [The company] deducted rent expenses for three meetings per month, once at each residence. Petitioners have not established that meetings occurred at that frequency."

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The decision demonstrates the "crucial principle" that provisions of the Internal Revenue Code "don't operate in isolation," certified public accountant Ed Zollars wrote on the Kaplan Financial Education Current Federal Tax Developments blog. The Masters exemption "does not automatically grant a blank check to charge any rental rate the taxpayer wishes without regard for reasonableness," Zollars wrote. He noted that the rule remains tied to the "fundamental" guideline of the code stating that business expenses must be "ordinary and necessary." 

"What exacerbated the situation for the taxpayers in this case was the related-party nature of the transaction," Zollars said. "When the same individuals have control over both the entity paying the rent and the entity receiving the rent, there's an inherent potential for abuse. Such transactions are often viewed with skepticism by the IRS and the courts, as they can be manipulated to siphon off corporate profits or to create deductions where they wouldn't normally exist."