Intercompany Fee Arrangement Lacks Economic Substance

If the employees and owners of a profitable C corporation set up a related entity and lease the employee-owner’s services back to the C corporation, can the C corporation deduct the payments?  Taking it a step further, what if the related entity is owned by a retirement plan so that most of the payments by the C corporation are not subject to Federal income tax?  The court addressed this in Pacific Management Group et al. v. Commissioner, T.C. Memo. 2018-131, highlighting the type of facts that have to be considered in tax savings arrangements that could be challenged based on economic substance.

Facts & Procedural History

The taxpayers were several related engineering companies.  They were owned by the same shareholders.  The companies were all taxed as C corporations.

The shareholders engaged a tax planning attorney, who came up with a plan to minimize their tax liability.  The plan included:

1. Forming a new S corporation to be owned individually by each of the taxpayer’s shareholders.
2. Each S corporation sponsored a separate ESOP retirement plan.
3. The ESOP retirement plans purchased the respective shares of the S corporations that sponsored them.
4. The shareholders each executed an employment agreement with their respective S corporations.
5. The shareholders then formed a partnership, with each of the S corporations being the general partners.  The partnership was “to provide business, management, and financial services to clients of the partnership.”
6. The partnership then entered into independent contractor agreements to make the shareholders of the taxpayer available to the taxpayer.
7. The taxpayer paid management fees to the partnership and deducted the fees on its Federal income tax returns.
8. The partnership remitted the fees to the S corporations–which likely reported an in-and-out wash for its Federal income tax purposes.
9. The S corporations paid the shareholders a base salary, which was subject to tax on the shareholder’s individual income tax returns, and the balance of the income to the S corporations was not subject to tax as the S corporations were owned by ESOP plans (the balance would be S corporation distributions that accrued to the ESOP).

There was also a factoring fee arrangement that had the same intent, to generate a deduction for the taxpayer and income that ended up in the ESOP.

Other than these transactions, the taxpayers business operations did not change.  The shareholders provided the same services.  The taxpayer’s customers were not aware of the new entities, etc.

On audit, the IRS disallowed the deductions for most of the management and all of the factoring fees.  The balance was treated as constructive dividends from the taxpayer to the shareholders.  Litigation ensued.

Ordinary & Necessary Business Expenses

The court started with the question of whether the fees paid were deductible as ordinary and necessary business expenses.  The courts have long held that the terms “ordinary” and “necessary” are as follows:

An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a common or frequent transaction in the type of business involved.  An expense is necessary if it is appropriate and helpful to the operation of the taxpayer’s business.

To fulfill these requirements, the transactions at question generally have to have economic substance.

The court applied these rules to the factoring and management fees.

The Factoring Fees

Because the factoring fees were not structured as a third party factoring company would (i.e., the factoring company did not even attempt to collect the receivables, the taxpayer was left with this obligation), the court had little difficulty in deciding whether these expenses are deductible:

We conclude that the purported factoring arrangement with [the partnership] had no economic substance but was a device to extract profits from the [taxpayer] in the guise of tax-deductible payments.  The [taxpayer] derived no economic benefit from this arrangement, and the factoring fees they paid were not “ordinary and necessary” expenses of their business.

The court did go into detail as to what factors are needed to make a factoring company arrangement valid in this arrangement.  Those with related-company factoring arrangements may need to ensure their arrangements line up with the factors identified by the court.

The Management Fees

The court then addressed the management fees the taxpayer deducted.  The general rule is that management fees are deductible if they are reasonable given the services performed.  This is a facts and circumstances analysis and the courts have developed factors that are to be considered.

Here, the court concluded that the fees were not reasonable as the shareholders did not perform services other than those previously provided as employees of the taxpayer.  The court noted that:

[the partnership]

was a paper entity, and its partners–the five S corporations–were likewise paper entities.
Neither [the partnership] nor the S corporations provided the [taxpayer] with actual management services of any kind. Rather, they were simply vehicles for supplying the personal services of the five principals, who performed for the [taxpayer] during 2002-2005 essentially the same services they had performed as direct employees of the [taxpayer] previously.

The outcome may have been different if, for example:

1. The shareholders performed different services to the taxpayer after the tax plan was put in place.
2. The shareholders, as independent contractors for the partnership, performed services for businesses other than the taxpayer.
3. The partnership functioned as a legitimate business, such as holding itself out to the public as such and obtaining its own clients.

In the absence of these types of facts, the court disallowed the taxpayer’s management fee deductions.

Constructive Dividends

With C corporations, constructive dividends are the result when there are transfers to the shareholders that are made out of the corporate earnings and profits (“E&P”).  Transfers in excess of this are return of contributions or capital gains.

In cases where the IRS  determines that a C corporation made non-deductible contributions and the C corporation has E&P, the IRS will typically say that the transfer was a constructive dividend.  This is true even if part or all of the transfer may arguably be deductible expenses, such as wages or compensation for services.

In this case, given that the court disallowed the management and factoring fee deductions, it had little difficulty concluding that the transfers were constructive dividends for the shareholders.