A common planning strategy for reducing taxable income in a “regular” subchapter C corporation is through the payment of management fees and other charges to related entities (generally-pass-through enterprises or individuals). Oftentimes, these expenditures take the form of excess compensation and/or management fees. However, the payment of these types of expenses does not sit well with the Internal Revenue Service (IRS).
The IRS often views these items as disguised dividends, which remain taxable as ordinary income to the recipient equity holders, but are nondeductible to the corporation. Such a recharacterization of these expenses by the IRS serves to invoke the “double taxation regime” implicit for regular corporations under the Internal Revenue Code of 1986.
To successfully defend these types of payments and strategies, it is incumbent upon the taxpayer to establish that the expenses have economic substance. To do so, the taxpayer not only must show that the expenses are “ordinary and necessary” to the operation of the business, but also must prove that the expenditures are “reasonable” in amount.
Recently, a rather complex case (Pacific Management Group, TC Memo. 2018-131), which ended with an adverse opinion for the taxpayers, illustrates the need for thoughtful planning in the development and implementation of strategies such as these. The case decision is interesting in that it goes into great detail on a number of matters challenging the validity of the adopted tax planning strategies. The full 80-page opinion can be found at the link above, but the case is summarized below.
The Tax Court case was a consolidated hearing involving four C corporations; five individual employees of those corporations; five S corporations that served as shareholders of the C corporations; five employee stock ownership plans; and, ultimately, a partnership.
In this case, certain amounts paid to the shareholders of multiple C corporations were deducted by those corporations in determining their taxable incomes. The Tax Court recharacterized the amounts previously paid and expensed as “factoring fees” and “management fees” as disguised distributions of corporate profits and constructive dividends, thereby affirming the adjustments proposed by the Internal Revenue Service.
Five individuals incorporated four C corporations and five S corporations formed into a partnership, through which cash was removed from the C corporations (taxable entities) in the form of alleged factoring and management fees, and treated them as deductible business expenses for tax purpose; thus, reducing a substantial amount of their taxable income. The partnership then distributed much of its cash to its five partners, each of which was an S corporation (pass-through entity), based on each individual’s ownership interest in the C corporations. Each individual received a salary from their respective S corporations in amounts deemed necessary to support living expenses. The individuals reported the amounts paid to them from the S corporations as taxable income, and all remaining amounts were reinvested by the S corporations for the individuals’ benefit.
The stock of each S corporation was owned by an employee stock ownership plan (ESOP), in which the individual who had formed the S corporation was the single participant and beneficiary. Since the ESOPs were tax exempt, the distributions the S corporations received from the partnership (net of the salaries/benefits paid to the individuals) were also exempt from federal taxation.
This strategy significantly reduced taxation of the operating profits at the C corporation level by passing the income to the S corporations. Because the S corporations’ stock was held by ESOPs, taxation at the individual shareholder level was deferred indefinitely, even though the profits had been distributed ratably for each shareholder’s benefit.
Challenges by the IRS
The IRS expert argued that the factoring arrangement (type of business finance arrangement) between the partnership and the C corporations was not an arm’s-length transaction. Because the five individual shareholders had no “nontax business purpose for the transaction,” the arrangement had no economic substance. In addition, the factoring did not provide meaningful financing to the C corporations since they were the ones providing the working capital to the partnership. Finally, the C corporations paid an annual percentage rate (APR) that was higher than the typical rate. As such, the court determined that the factoring fees paid were neither necessary nor reasonable. Also, the fact that the C corporations were not in need of the factoring suggests that the payments may have also failed to meet the “ordinary and necessary” clause under Section 162 of the Internal Revenue Code of 1986.
The IRS also disputed the bonus payments made to the shareholders as part of the management fees, asserting the amounts paid were unreasonable compensation for the services provided by the individuals, and did not qualify as “ordinary and necessary” business expenses. They argued that there was no structured bonus plan, an obvious conflict of interest, and an alleged intent “to disguise nondeductible corporate distributions of income as salary expenditures.” The court agreed, and allowed the deduction for bonuses at a much lower level.
The IRS maintained that each of the five individuals received unreported income based on the various corporate payments. The disguised expenses represented either compensation for services or distributions, either paid or held and invested for the benefit of the individuals. The IRS sought to collect taxes from the individuals on this unreported income.
Take-Away for Taxpayers
There is no question that the use of an ESOP to facilitate these strategies was a significant factor that caused the IRS to focus on these transactions. In effect, the structure can be characterized as a tax shelter scheme.
While an ESOP can be an invaluable planning strategy in the right circumstances, it is not difficult to see the abuse created here by adopting an ESOP for each single owner with no other employees. The intent of Congress in facilitating these plans was not to benefit the structure set forth in this case.