Related party transactions can raise difficult tax questions. This is especially true for management fees paid by one legal entity to another legal entity that has the same or similar owners or that are controlled by the same owners.
As noted in the recent Wycoff v. Commissioner, T.C. Memo. 2017-203 case, related-party management fees often raise difficult valuation issues and can result in sizable tax adjustments.
The Facts and Procedural History
The taxpayer formed two businesses that manufactured and marketed household cleaning products. The businesses were both taxed as Subchapter S corporations.
The taxpayer performed management, marketing, and other functions for the businesses.
The taxpayer took the following steps as part of a tax-motivated plan:
- Form a new S corporation.
- Have the new S corporation set up a rabbi trust for the Taxpayer’s benefit to receive up to 80% of the new S corporation’s earnings, which would be distributed when the taxpayer stopped working for the new S corporation.
- Have the new S corporation adopt a 401(k) plan (KSOP) and an employee stock ownership plan trust (ESOP trust) and sell the new S corporation stock to the KSOP/ESOP for $1,000.
- Have the new S corporation hire the taxpayer to provide management services to the two existing S corporations by working for the new S corporation.
- Have the new S corporation enter into management contracts with the existing S corporations.
The intent of was to allow the existing S corporations to deduct management fees for amounts paid to the new S corporation. Then, in turn, the new S corporation would not report any taxable income from the arrangement as it was tax exempt entity (i.e., a KSOP/ESOP).
The management fees paid by the existing S corporations were $1,094,393, $8,413,486, $1,236,198, and $328,075 for 2000 to 2003.
The IRS did not challenge the business structure. The IRS only challenged the tax deduction for the management fees.
Both parties put forth valuation experts who opined on whether the amount of the management fees were arm’s length under Section 482.
Section 482 Valuation, Generally
Section 482 provides a mechanism for the IRS to re-allocate income, deductions, etc. for transactions between commonly controlled entities. These transfer pricing cases ask whether the charges are what third parties would be willing to pay. There are a number of ways to determine the value of management fees.
The taxpayer presented testimony from an industry expert who was not a valuation expert and an opinion by a valuation expert. The valuation expert considered comparable compensation data for companies in an unrelated industry, a compensation analysis based on the hours the taxpayer worked, and reviewing an executive compensation survey. The court did not accept these methods.
The IRS’s expert used the more traditional comparable profits method. This method identifies the business’ costs and applies a median profit margin for a comparable group of companies that are not related to each other or controlled by each other. In his analysis, the IRS expert reduced the new S corporation’s expenses by the amount of compensation that was deemed to be excessive.
The court accepted the IRS expert’s method and, given the facts indicating that the compensation was unreasonable, it accepted the adjustment for the taxpayer’s compensation.
This reduced the management fee deduction for the existing S corporations from $10.7 million to $3.7 million. Ouch!
In 40 minutes, we'll teach you how to survive an IRS audit.
We'll explain how the IRS conducts audits and how to manage and close the audit.