Landlords often provide a construction allowance to tenants to build-out or improve the leased premises. Under Code Section 110, for retail establishments such a construction allowance will often be excluded from income. However, if the construction allowance is not fully used to improve the premises, the excess is taxable to the tenant.
The IRS Chief Counsel recently addressed a situation where a construction allowance was not fully used by the tenant. Since the tenant was a corporation, the issue was raised whether the unused portion could be treated as a nontaxable contribution to capital.
Under Code Section 118, a contribution to the capital of a corporation is not included in the corporation's gross income. This is true even if the contributor is not a shareholder.
In analyzing the situation, the IRS first addressed the general requirements for treatment as a capital contribution under Section 118. Section 118 does NOT apply if the transferor is motivated by a desire to obtain specific, quantifiable benefits. If the transferor expects to receive only vague, uncertain, or incidental benefits, a transfer is likely to be a contribution to capital, if it satisfies five factors: (1) it must become a permanent part of the transferee's working capital structure; (2) it can't be compensation, such as a direct payment for a specific, quantifiable service provided for the transferor by the transferee; (3) it must be bargained for; (4) the asset transferred must foreseeably result in benefit to the transferee in an amount commensurate with its value; and (5) the asset ordinarily, if not always, will be employed in or contribute to the production of additional income and its value assured in that respect.
The IRS noted that a construction allowance provided by a landlord to a tenant is motivated by the landlord's desire to have the lessee operate a retail store in the lessee's retail property and receive rent. The existence of a lease under which rent is payable to the lessor was held by the IRS to be a sufficient direct benefit to take the construction allowance outside the scope of Section 118 and thus tax the portion not applied to construction.