This week, we return to two recurring themes of this blog: (I) related party transactions – specifically, transactions between a taxpayer and a corporation controlled by the taxpayer; and (II) what happens when a taxpayer does not conduct the appropriate due diligence before engaging in a transaction.

Management Agreements

Taxpayers owned two operating companies (the “OCs”) that were treated as S-corporations for tax purposes. Taxpayers were the sole officers and directors of the OCs. Taxpayer One (“TP-1”) was primarily responsible for all operations of the OCs. His principal duties included: negotiating contracts, overseeing advertising purchases and content, managing the OCs’ finances, selling the products to retailers, and overseeing other employees’ work. In short, he performed all managerial tasks for the OCs.

Taxpayers’ attorney advised them that they could reduce their income tax liabilities by way of a series of transactions that included the use of a new management corporation.

TP-1 directed the attorney to implement the transactions. Accordingly, Management Corp (“MC”) was incorporated, Taxpayers were appointed as its directors, and TP-1 was designated as its president. MC then issued shares of stock to the Taxpayers, who elected that MC be taxed as an S-corporation.

The OCs entered into management agreements with MC. The agreements did not specify the particular services that MC’s employees would provide. Under these agreements, the OCs agreed to purchase management services from MC for 20% of their respective gross receipts.

This management fee was determined by TP-1, with input from his legal and tax advisers. The OCs and MC did not retain a professional consultant to assist with setting the amount of the management fee or to advise with respect to reasonable compensation.

MC then hired TP-1 to “provide management services to the client companies of * * * [MC] so as to fulfill the obligations of * * * [MC] under its various management agreements”. The contract between MC and TP-1 did not specify the particular “management services” that TP-1 was to provide. However, TP-1 provided the same services to the OCs that he had provided to them before incorporating MC.

The OCs’ functions did not change after they had hired MC, except that the employees of the OCs began providing services via MC. Employees were not aware of this change until they began receiving their salaries from MC. For all practical purposes, the work of OCs’ employees did not change when they began working for MC.

The OCs and MC subsequently amended their respective management agreements to provide that the OCs would pay MC 10% of their respective gross receipts for MC’s services because the OCs’ revenues had declined. They later amended the agreements to provide for a 3% fee. Regardless of the size of the fee, MC purportedly provided the same services to the OCs for the years at issue.

Notice of Deficiency

The IRS issued a notice of deficiency to Taxpayers in which it disallowed the deductions claimed on their respective tax returns (on IRS Form 1120S) for the management fees that the OCs reported paying to MC.

The IRS contended that Taxpayers were entitled to deduct only the portions of the management fees that were considered reasonable.

The IRS also argued that, to the extent the management fees constituted unreasonable compensation, the transaction should be re-characterized as distributions by the OCs to the Taxpayers.

As an alternative position, the IRS stated that MC should be disregarded as a sham for tax purposes because it lacked a legitimate business purpose and had no economic substance, in which case no part of the management fees would be deductible.

The Taxpayers petitioned the U.S. Tax Court.

On brief, the IRS conceded that MC was not a sham entity and should not be disregarded.

The Court’s Analysis

Because the IRS conceded that MC was not a sham entity, the Court focused on determining what constituted an arm’s-length management fee, which it noted may be higher than the salaries MC paid (i.e., there would be a profit).

The Court began by reviewing those Code provisions that were enacted to prevent tax evasion and to ensure that taxpayers clearly reflected income relating to transactions between controlled entities. The IRS, it stated, had broad authority to allocate gross income, deductions, credits, or allowances between two related corporations if the allocations were necessary either to prevent evasion of tax or to clearly reflect the income of the corporations.

To determine “true” taxable income, the Court continued, the standard to be applied in every case was that of a taxpayer dealing at arm’s-length with an uncontrolled taxpayer. The arm’s-length result of a controlled transaction must be determined under the method that, under the facts and circumstances, provides the most reliable measure of an arm’s-length result. In determining which of two or more available methods provides the most reliable measure of an arm’s-length result, the two primary factors to take into account are the degree of comparability between the controlled taxpayer and any uncontrolled comparable, and the quality of data and assumptions used in the analysis.

Arm’s-Length Fee?

The task before the Court was to determine the most reliable method for calculating an arm’s-length management fee. It began its analysis by reviewing the Taxpayers’ and the IRS’s expert reports.

The Court found that the methodology used by the Taxpayers’ expert was unreliable because the companies on which the expert relied were not comparable to the OCs.

It then turned to the IRS’s expert report.

The IRS’s expert determined that an appropriate method for calculating an arm’s-length management fee – what unrelated parties would have paid for similar services – was a markup of MC’s expenses. His method required that, after determining MC’s costs, he multiplied them by the median profit margin of a comparable group of companies for the particular year at issue.

The IRS’s expert researched companies comparable to MC in terms of revenue and services provided. He did this by first determining the operating profits earned by comparable companies as a percentage of their total costs.

Next, he determined the cost markups of these comparable companies for the years at issue. He then calculated MC’s costs by using MC’s reported expenses for the years at issue, but subtracting that portion of the expenses he considered to be unreasonable compensation to TP-1.

After allowing for a deduction of an arm’s-length management fee, the IRS’s expert calculated the OCs’ three-year average operating income margin. Because this margin was within the three-year average for the OCs’ peer group, he considered his results reasonable.

Reasonable Compensation

The Taxpayers contended that the IRS’s analysis was unreliable because it had determined that TP-1 was overcompensated.

The Court explained that a taxpayer is entitled to a deduction for compensation payments if the payments are reasonable in amount and are, in fact, paid purely for services. The question of whether amounts paid to employees represent reasonable compensation for services rendered is a question of fact that must be determined in the light of all the evidence.

Special scrutiny is given, the Court continued, in situations where a corporation is controlled by the employees to whom the compensation is paid because there is a lack of arm’s-length bargaining.

It also noted that contingent compensation agreements (like the fee paid to MC) generally invite scrutiny as a possible distribution of earnings, though the courts have upheld such agreements under appropriate circumstances. If a contingent compensation agreement generates payments greater than the amounts that would otherwise be reasonable, those payments are generally deductible only if: (1) they are paid pursuant to a free bargain between the employer and the individual; (2) the agreement is made before the services are rendered; and (3) the payments are not influenced by any consideration on the part of the employer other than that of securing the services of the individual on fair and advantageous terms.

Where there is no free bargain between the parties, the contingent compensation agreement is not dispositive as to what is deductible. Rather the Court is free to make its own determination of what is reasonable compensation.

The Court identified the following factors to determine the reasonableness of compensation, with no one factor being determinative: (1) the employee’s qualifications; (2) the nature, extent and scope of the employee’s work; (3) the size and complexities of the business; (4) a comparison of salaries paid with the gross income and net income; (5) the prevailing economic conditions; (6) a comparison of salaries with distributions to shareholders; (7) the prevailing rates of compensation for comparable positions in comparable concerns; (8) the salary policy of the taxpayer as to all employees; and (9) in the case of small corporations with a limited number of officers, the amount of compensation paid to the particular employee in previous years.

According to the Court, shareholder-executive compensation in a closely-held corporation that depletes most of a corporation’s value is generally unreasonable when the deductible salary expenses are a disguise for nondeductible profit distributions.

Taxpayers owned the OCs. In this case, the management fee depleted most, if not all, of the OCs’ profits. The management fee in turn was used primarily to pay TP-1. For example, approximately 87% of the management fee went to pay TP’s compensation in one of the years at issue.

In summary, the Court found that TP-1’s compensation was unreasonable, and that the IRS correctly adjusted his compensation before calculating an arm’s-length management fee. In calculating TP-1’s reasonable compensation, the IRS analyzed executive compensation of companies engaged in a comparable business and found that TP-1’s compensation was substantially more. Therefore, the Court found that the IRS’s conclusions regarding TP-1’s reasonable compensation were reliable.

The Court concluded that the IRS’s determination produced the most reliable measure of an arm’s-length result under the facts and circumstances. Accordingly, the Court reduced the amount that the OCs were entitled to deduct as management fees.

Lesson Learned?

You may be surprised at how frequently the IRS challenges the reasonableness, or even the nature, of the payments that are made between related taxpayers, and especially between related, closely-held businesses.

Over the years, the IRS, Congress, and the courts have developed a number of theories by which to force taxpayers to report the true income resulting from transactions with related persons, including the following: sham transaction, sham entity, substance over form, economic substance, assignment of income, “true earner,” reallocation of income, re-characterization of income, and others.

In almost every case, the best defense against an IRS challenge of the taxpayer’s treatment of a “related party transaction” is established in advance of the transaction.

The taxpayer should determine whether the transaction would be undertaken without regard to its tax consequences; whether there is an independent and bona fide business purpose for the transaction. If these inquiries cannot be answered in the affirmative, the taxpayer should avoid the transaction.

Assuming there is an independent business purpose for the related party transaction, the taxpayer may structure it in a tax-efficient manner. However, the taxpayer must also act to structure the transaction with the related party, as closely as reasonably possible, on an arm’s-length basis, and it should document its efforts and compile the data (such as comparables) and other evidence (for example, expert reports) on which it based its conclusions.