Florida businesses often hold real property and their business operations in separate entities for liability purposes. While this is a very standard and effective way to mitigate the liability risk of owning commercial real estate, these types of structures need to be mindful of the sales tax rules.
Usually rental agreements are put in place between the operating entity (Lessee) and the real estate entity (Lessor) with rent either equal to the mortgage payments, taxes, and insurance for the building or to some percentage of revenues of the operating entity. Occasionally, no rental agreement is put in place and the operating entity simply pays the mortgage, insurance, and taxes for the real estate entity. In most states, this does not create any significant tax problems. However, as anyone with a little bit of multi-state tax knowledge will tell you, what is true in most states is not true in every state.
Florida is one of the very few places in the country where commercial rental agreements are subject to sales tax at a state rate of 6% plus a local option rate of up to an additional 1%. Even most tax professionals are surprised to find out that sales tax is imposed on commercial rents when the lessor and lessee are commonly owned. The most surprising fact is that unlike the Federal income tax realm, Florida considers disregarded entities as separate legal entities for Florida Sales and Use Tax purposes. This has the effect of blindsiding many businesses, surprisingly some of which are wholly owned and operated in Florida.
What constitutes as rental payments for sales tax purposes?
The most obvious answer is “the amount stated in the lease agreement for the right to use or occupy the commercial property.” However, most lease agreements are not that simple. If a tenant is required to make payments of any kind on behalf of the landlord (such as include mortgage, real estate taxes, insurance, CAM expenses or any other payments required under the lease agreement), these payments can still can be characterized as rent and be subject to sales tax. Any payment or agreement between a tenant and lessor should be evaluated for sales tax implications.
Leasehold improvements that are required under the lease agreement can also constitute rent if paid for by the tenant, depending on the language and intent of the lease agreement. Factors to consider include the improvements required, whether the improvements revert to the landlord at the end of lease, whether they were in lieu of rent, and whether credit was given against rent. If such situations pertain to you, we recommend consulting your tax advisor or legal counsel due to the variances of each lease agreement or situation.
What if there is no lease agreement?
Even if no rental agreements are put into place and rents are never paid, if the operating entity pays the mortgage, insurance, or taxes for the real estate entity, then Florida takes the position that these amounts are the equivalent to rent and impose the sales tax on the payments made by the operating entity on behalf of the real estate entity. This too catches many companies off guard because when competent counsel does only a cursory reading of the relevant statutes – they could easily assume that if no rental agreements are in place and nothing is labeled “rent,” then no sales tax would be due. The Florida Department of Revenue has been very successfully imposing sales taxes on the indirect payment of rent when the obligations of the real estate entity are paid directly by the operating entity. (See the US Cardio Vascular Inc vs FL DOR).
The Florida Department issued the following guide “Sales and Use Tax on the Rental, Lease, or License to Use Commercial Real Property” and states the following:
Rentals, leases, and licenses to use or occupy commercial real property by related persons, as defined in section (s.) 212.02(12), Florida Statutes (F.S.), are subject to sales tax and surtax. For example, the lease of commercial real property by a parent corporation to one of its subsidiaries, or by a shareholder to a corporation, or by an individual property owner to a related single member LLC, is subject to sales tax and surtax.
Because most Florida tax audits cover periods of 3 years, the imposition of up to a 7% tax, plus up to 50% penalty and interest can add up to a staggering amount. It is really disheartening because the entire tax amount on purely intercompany transactions could have been avoided with a little planning and advice from a trained Florida tax advisor.
What should I do?
If you or your client realizes that this situation applies to your company and you have Florida sales tax exposure on intercompany rental income, then there are ways to minimize the impact of the past transactions and to substantially lessen or possibly eliminate the sales tax on rents issue going forward. For example, a rental agreement for $1,000 annually would only be subject to approximately $70 of sales tax. You would still need to get the funds from the operating entity to the real estate entity to pay expense, but there are ways to do that safely too if proper planning is put in place and followed to a T (for example – profit distributions to a common parent).
If you are caught on audit treating the payments as “rent” on both your books and your federal income tax returns, then there is an alternative argument that takes a little more time to make. The argument is that you made a mistake calling the payments rent. You must amend your federal income tax returns and books to even begin making this argument and this audit defense strategy may have other non-sales tax consequences. Finally, this position is not guaranteed to win because it is very fact dependent, but it is an argument that we have made successfully multiple times in the past.