Do you operate your business from a building you own or are purchasing? Then you may be able to lower your overall tax bill through a leaseback arrangement. This tax strategy involves forming a separate business entity to own the building, which then leases that space to the operating business and receives rent for its use.
While leasebacks can be great tax savings tools, you must follow a few key rules in order to avoid trouble with the IRS. Here are four of the most important and why.
1. A Written Agreement
It may sound a little silly if you own both entities, but you will need to draft a legitimate lease contract between them. This lease agreement should have all the standard clauses, including when the rent is due, penalties for late payment, and expectations of each party. The IRS expects you to treat this like a normal lease between landlord and tenant.
2. Monthly Rent Payment
If they audit, the IRS will look for signs that this is not a real lease but an attempt to abuse the system. One clear sign of the latter is failure to actually pay the rent on time each month. The business is not allowed to just transfer the equivalent amount at the end of the year, for instance, after holiday sales have boosted cash flow. You may either pay that bill each month or prepay for a period.
3. Market Rental Prices
What will you charge your own business for rent? Do not artificially inflate the rent amount, since this is another red flag that it's not a real business lease. Research market rental rates in your area for this type of commercial property. Charge only within this limit, including any reasonable annual increases (like cost-of-living adjustments).
4. Good Recordkeeping
Keep standard records of this transaction just as you do your other business income and expenses. Records include ledgers — handwritten or in accounting software — showing income and expenses. There should be bank statements as well as canceled checks and deposit slips tracking money as it flows through both entities.
Where to Learn More
A leaseback agreement is a good way to claim many more tax deductions than you otherwise could. But the IRS will be looking for signs of misuse. Prevent any trouble by working with an experienced accountant who specializes in business tax preparation. With their help, you'll maximize profits with this strategy while minimizing problems.
Contact a service provider like Martinson & Carter CPAs, PA to learn more.
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