The Adviser’s Dilemma

The tax adviser to a closely held business is often “encouraged” by his client to find ways to reduce the client’s federal, state and local tax bills. One obvious way of accomplishing this goal is by claiming a deduction for a business-related expense. NYC UBT

In considering whether such an expense is, in fact, deductible by his client, the adviser must bear in mind two basic principles of tax law: provisions granting a deduction are construed in favor of the taxing authority, and the extent to which a deduction is allowed is a matter of legislative grace to which the taxpayer must prove entitlement.

Sometimes, in his eagerness to save a client money, an adviser may fail to consider an issue thoroughly, including the arguments that a taxing authority may raise against the client’s position. As a result, additional professional fees are incurred in defending the taxpayer’s position, the desired tax benefit is lost, and penalties are often imposed. These consequences were illustrated in a recent decision involving a deduction claimed in calculating a taxpayer’s liability for New York City’s unincorporated business tax (“UBT”).

The UBT

The UBT is imposed on the unincorporated business taxable income of every unincorporated business carried on within the City. An unincorporated business includes a partnership.

The unincorporated business taxable income of an unincorporated business is defined as the excess of its unincorporated business gross income over its unincorporated business deductions.

The unincorporated business deductions are the items of loss and deductions directly connected with or incurred in the conduct of the business, and which are allowable for federal income tax purposes for the taxable year, subject to certain modifications.

One of those modifications provides that no deduction is allowed to a partnership for amounts paid to a partner for services rendered by the partner. This is to be contrasted with payments by a partnership to partners that represent the value of any services provided to the partnership by the employees of the partner, for which a deduction is allowed.

Partner or Employee Services?

Limited Partnership (“LP”) had no employees – all of its activities were performed by its sole general partner (“GP”), an S corporation. GP’s employees serviced LP’s clients.

GP charged LP an annual management fee (the “Fee”) for the services it provided to or on behalf of LP. The amount of the Fee was based on the expenses the GP incurred to provide its services. The largest component of those expenses was the compensation GP paid to its employees for the services rendered to LP.

GP did not report the Fee as income for the Tax Year on its federal and UBT tax returns. Nor did it deduct the related expenses, including the compensation paid to its employees. Instead, LP reported each of GP’s operating expense items comprising the Fee, including the compensation GP paid to its employees who performed services for LP, as deductions on the corresponding lines of LP’s federal partnership income tax return (IRS Form 1065) and UBT return (Form NYC-204). As a result, all of the expenses GP incurred to operate LP were reported by LP as if LP had incurred them.

Although LP had no employees of its own, on its tax returns LP deducted as salary and wages the portion of the Fee it paid for the services of GP’s employees. GP, however, issued forms W-2 and filed employment tax returns to report the compensation paid to its employees.

At the beginning of the Tax Year, GP underwent a restructuring in which its employee-shareholders redeemed their shares in GP and were given limited partnership interests in LP. On the same date, additional employees of GP were given limited partnership interests in LP. As a result, following the restructuring, many of GP’s employees became limited partners in LP.

On LP’s UBT return for the Tax Year, LP deducted compensation paid to GP’s Employee-Partners.

The ALJ Disagreed . . .

The City audited LP’s UBT return for the Tax Year and disallowed LP’s deductions for salaries paid to the Employee-Partners and for amounts paid to the Employee-Partners’ pension plans.

The City asserted a UBT deficiency against LP, and an ALJ sustained the deficiency, concluding that LP’s payments to the Employee-Partners for their services were not deductible under the UBT rules.

The ALJ concluded that under the statute it was irrelevant that the payments were for services performed in a dual capacity, as employees of GP and as partners of LP, or that the payments were made to GP rather than directly to the Employee-Partners.

LP contended that the amounts it paid to GP for the services of the Employee-Partners were not amounts paid or incurred to a partner for services under the UBT rules because the Employee-Partners were employed by GP and performed the services for their employer (GP), not LP.

LP further contended that its payments fell within an exception to disallowance of the deduction under the UBT rules (the “Exception”). The Exception provides that payments to a partner for services are allowed as a deduction to the extent attributable to the services of the partner’s employees. LP argued that it satisfied the requirements of the Exception because the Employee-Partners were employees of GP. In addition, LP asserted that it was irrelevant to the operation of the Exception that the Employee-Partners are also partners in LP.

The City countered that, as a matter of substance, the payments in question were made to GP for the services of the Employee-Partners (who were partners in LP) and, therefore, were not deductible under the UBT rules.

. . . So Did the Tribunal And . . .

The NYC Tax Appeals Tribunal affirmed the ALJ’s determination, and LP appealed to the Appellate Division, which affirmed the Tribunal in a summary decision.

LP paid a management fee to GP for its services. According to the Tribunal, because the payment was to a partner for services, the UBT rules denied a deduction for the entire amount of the payment.

The Exception carves out an exception to the denial of the deduction where the partner’s services are performed by employees of the partner. The Exception provides:

. . . payments to partners for services do not include amounts paid or incurred by an unincorporated business to a partner of such business which reasonably represent the value of services provided the unincorporated business by the employees of such partner, and which . . . would constitute allowable business deductions . . . . The amounts paid or incurred for such employee services must be actually disbursed by the unincorporated business and included in that partner’s gross income for Federal income tax purposes.

Strike One

LP read the Exception broadly to include compensation paid to any employee of GP, regardless of whether the employee was also a partner in LP. Thus, LP contended that, under the Exception, LP could deduct the portion of its payment to GP representing compensation for the services of the Employee-Partners.

The Tribunal rejected LP’s reading of the Exception. LP’s reading of the Exception, it stated, was incompatible with a clear statutory policy to deny a deduction for payments to a partner for services.

Significantly, the UBT rules provide:

Amounts paid or incurred to an individual partner of the unincorporated business for services provided the unincorporated business by such an individual shall not be allowed as a deduction . . . .. The fact that the individual is providing such services not in his capacity as a partner within provisions of Sec. 707 of the Federal Internal Revenue Code will not change the result. (emph. added)

Under the UBT rules, LP’s payments to an individual partner for services were not deductible. The Employee-Partners were not merely employees of GP but were also individual partners in LP.

According to the Tribunal, the UBT rules made it clear that LP’s payment to GP for the services of the Employee-Partners was not deductible. Similarly, LP’s overly broad interpretation of the Exception, to allow a deduction for the services of a partner’s employees who are also partners, had to be rejected as contrary to the statute.

Strike Two

The Tribunal also rejected LP’s related argument that the portion of the Fee paid to GP representing compensation to the Employee-Partners was deductible because it was paid for services of the Employee-Partners in their capacity as employees, not as partners. The Tribunal pointed out that General Partner did not report the Fee as income on its federal and UBT tax returns. If the payment was not reported as income, it was rational for the UBT rules to deny the deduction, it stated.

Furthermore, because LP reported GP’s employees, including the Employee-Partners, as its own employees on its federal and UBT tax returns, the Exception did not apply. It applies only to payments for the services of a partner’s employees, not employees of the unincorporated business. The form in which LP reported its income and expenses removed it from the scope of the Exception.

Strike Three

LP argued that it did not pay the Employee-Partners for their services. Instead, it paid a Fee to GP which, in turn, compensated its employees for the work performed for GP. Therefore, LP argued the payments were not amounts paid to a partner. The Tribunal responded that this argument ignored the fact that LP paid the Fee directly to GP, who performed the services directly for LP.

In advancing this argument, LP took the position that payments to GP for the services of the Employee-Partners were payments to a third party and not within the scope of UBT Rules, which LP read as applying only to amounts paid directly to a partner. LP argued that the City had no authority to elevate substance over form to disallow third-party payments for partner services.

The Tribunal rejected this argument, holding that the taxing authority was not bound by the form of the payments, and could look to the economic substance of an arrangement to determine its tax consequences:

Tax legislation should be implemented in a manner that gives effect to the economic substance of the transactions . . . and the taxing authority may not be required to acquiesce in the taxpayer’s election of a form for doing business but rather may look to the reality of the tax event and sustain or disregard the effect of the fiction in order to best serve the purposes of the tax statute . . . .

The Tribunal considered the substance of the payments and found that they were not deductible, regardless of whether they were made directly to the Employee-Partners or to GP for their services.

Did You Notice?

LP had one argument that it presented in three slightly different ways. This argument failed at the audit stage, it was rejected by the ALJ, and then by the Tax Appeals Tribunal. Was it any surprise that the Appellate Division dismissed it with a summary decision?

It bears repeating: a deduction is a matter of legislative grace, and the provision granting it will be construed in favor of the taxing authority.

To make matters worse, in the present case, the UBT rules expressly stated that amounts paid to a partner for services were not deductible by the partnership regardless of the capacity in which such services were provided.

As always, it will behoove the tax adviser, and ultimately the closely held business client, to proceed with caution and to be thorough in his approach toward the issue being addressed before recommending a course of action. This includes a consideration of the arguments that will be presented in defense of one’s position in the event it is ever challenged by a taxing authority. No time like the present.