Related Party Expenses

It is not unusual for one close corporation to pay the expenses incurred by a related corporation or business. There are many circumstances in which such a payment may occur, but they share one overriding theme: the related corporations view themselves – or, more properly, their owners view them – as a single economic unit or business enterprise.

For example, one corporation (the “Obligor”) that has incurred a business expense or liability may not have the funds with which to satisfy the expense, while its parent or sister corporation (the “Payor”) has excess cash available. Rather than contributing or lending the funds to the Obligor, the Payor may simply choose – i.e., its owners may cause it – to pay the expense directly itself. Then, at the end of its tax year, the Payor will often claim the payment as a deductible business expense, thereby reducing its taxable income.

The IRS and the courts have a long history of examining such scenarios and of recharacterizing the “flow of funds” between the related corporations to reflect the tax consequences that would have resulted if the parties had dealt with one another on an arm’s-length basis.

The Chief Counsel’s Office of the IRS recently considered a case in which a corporation paid certain expenses related to services that were rendered for the benefit of a joint venture in which the corporation was a member.  Interestingly, however, this “field attorney advice” did not involve the corporation’s payment of an unrelated party’s fee for such services, nor did it involve the payment of wages to the joint venture’s employees. Rather, the advice addressed the corporation’s payments to its own employees in respect of services performed for the joint venture.

Constructive Capital Contribution

The Code allows a deduction for ordinary and necessary business expenses, including a reasonable allowance for salaries or other compensation for personal services actually rendered.

It is implicit in the Code that a taxpayer generally may not deduct the expenses of another taxpayer, even though those expenses would otherwise be ordinary and necessary trade or business expenses. A parent corporation may not, therefore, deduct compensation paid by it to the employees of its wholly owned subsidiary, even though the indirect benefit of their services inures to the parent corporation as the sole shareholder of the employer-subsidiary.

There is, however, a limited exception to this rule: A deduction may be allowable by a corporation if it paid the related corporation’s business expense for its own direct and proximate benefit, or if the expense was incurred by the corporation with the underlying motivating purpose of protecting and promoting its own business (as opposed to that of the related corporation).

In order for compensation payments to be for a taxpayer’s own direct and proximate benefit, the taxpayer must prove that the specific services performed by the employees involved were for its direct and proximate benefit. The indirect benefit that inures to a parent corporation when one of its subsidiaries successfully performs its functions does not satisfy the requirements for a business deduction by the parent.

For example, the IRS held in Rev. Rul. 84-68 that a parent corporation may not deduct as a business expense the cash bonuses that it pays to the employees of its wholly-owned subsidiary.  Instead, because the payments by the parent-shareholder were made to protect its investment in the subsidiary, they represented an additional cost (basis) for its subsidiary shares, and should be treated as an additional contribution to the subsidiary’s capital, accompanied by a constructive payment by the subsidiary of the cash bonuses to its employees, for which the subsidiary was entitled to a ordinary business deduction.

 The Joint Venture Expenses

In this case, the taxpayer-corporation paid for services performed on behalf of the joint venture of which it was just one member.

According to the IRS, “[a] contribution to capital need not be made pro rata with contributions from other shareholders. . . [and] a payment to a corporation can be a capital contribution even if some shareholders contribute less than others or nothing at all.” Moreover, a contribution to capital may occur even if it “is not recorded as a contribution to capital on the corporation’s balance sheet.”

The IRS analogized the situation to Rev. Rul. 84-68 stating that expenses paid by a taxpayer-shareholder for the operation of a subsidiary’s business that do not provide a proximate and direct benefit to the taxpayer are not deductible by the taxpayer.

The IRS acknowledged that this case differed from Rev. Rul. 84-68 in that the taxpayer paid its own employees, not the joint venture’s employees, and the joint venture was, of course, not wholly-owned by the taxpayer.

With respect to the former, the IRS noted that payments to the employees of the taxpayer-parent for services performed on behalf of a subsidiary – which did not provide a proximate and direct benefit to the taxpayer – would be treated the same way as payments to the subsidiary’s employees: as a capital contribution by the taxpayer to the subsidiary.

With respect to the latter, a less than 100 percent shareholder may make a capital contribution even though it is not made pro rata with contributions from other shareholders and some shareholders contribute nothing at all. Similarly, the fact that the joint venture did not record the payment of the expenses as a contribution to its capital did not stop the contribution to capital from being treated as having occurred for tax purposes.

Therefore, the IRS concluded that the payment of expenses for the services provided to the joint venture by the employees of one of its members should be treated as a contribution of additional capital to the joint venture by the taxpayer-member, accompanied by a constructive payment of the expenses by the joint venture from its own funds, for which the joint venture was entitled to a business deduction.

Takeaway

It is sometimes difficult for the owners of related close corporations to remember that the corporations are, in fact, separate taxpayers. Business exigencies or, more frequently, convenience may cause the owners to ignore corporate formalities, sometimes generating unexpected results like the ones described above.

In order to avoid the IRS’s recharacterization of payments made between related corporations or other businesses, or of payments made by one related corporation on behalf of another, it is important that the owners of such businesses consider the tax consequences thereof before making the payments. This will require that they properly identify the reason for and nature of the payment, and that they contemporaneously document the flow of funds that actually occurs, or is deemed to occur. As always, the related businesses should endeavor as much as possible to approach their intercompany transactions as if they were unrelated parties.