In the current real estate climate, shared workspace environments are the hot topic of the day, whereby companies or individuals pay to use office space, along with a host of other services. Contracts to utilize such spaces are often crafted as service agreements, rather than leases.
This practice is about to pay some dividends on the financial reporting side, as such agreements may be able to be scoped out of the new lease accounting standard that is now effective for public companies and soon to be effective for nonpublic companies. The biggest benefit of this exception is that tenants (lessees) would not have to capitalize the present value of future minimum payments under the contracts and create potentially large liabilities on their balance sheets under GAAP reporting. This helps to make the arrangement more attractive to potential tenants.
Service providers (lessors), however, may be setting themselves up for an additional out-of-pocket cost if the property is located in Manhattan, south of 96th Street. This line of demarcation in the tax world in New York City relates to the “expense tax” known as the Commercial Rent Tax (CRT). Only in New York City are lessees provided the “opportunity” to pay a tax on an expense. Very often, service providers lease space from unrelated landlords. That rent expense paid by the service providers would be subject to the CRT. An offset against rent expense is permitted for any sublet rental income for CRT purposes. However, since the service agreement revenue does not constitute rental income, it cannot be used to offset rent expense. The CRT is payable at a net 3.9% rate, so service providers must include such a cost in their business models to ensure they are pricing out their contracts appropriately.
In short, the service agreement model does have its benefits, but, when utilized within Greater Manhattan, it comes with a pitfall that should not be ignored.