Originally published on Forbes.com June 7th, 2013
Many accountants have a touching faith in double entry. They think that you can move income from one related entity to another with magical journal entries. Management fees are among the favorites. That type of magical thinking was probably behind the unfortunate result in the recent Tax Court decision in the case of Wiley and Sharon Elick and Wiley M. Elick, DDS Inc. Doctor Elick practiced pediatric dentistry, which can be pretty lucrative. It takes a certain flair to keep the kids happy. Doctor Elick was also involved in a center called SurgiTek.
Let’s Have An ESOP
An ESOP (employee stock ownership plan) can yield all sorts of nifty benefits, significant income deferral being among them. We can’t tell from the case the exact benefits Dr. Elick hoped to reap from an ESOP, but there must have been something. It is not mentioned in the case, but there was a legal problem to overcome. Professional corporations generally can only have licensed professionals of that particular profession as shareholders. ESOPs are neat vehicles, but you can’t teach them how to do fillings, so they can’t be shareholders in dental professional corporations.
The solution was to form a dental management company:
A professional advised Dr. Elick to establish a company to manage petitioner’s operations. A stock ownership plan benefiting petitioner’s employees would purchase the company stock from Dr. Elick. The fees generated by management services would fund the employee benefit plan.
Dr. Elick set up the proposed structure with the professional’s assistance. Dr. Elick became the sole owner of an existing corporation, SD Management Group, Inc. (SDG). SDG established an employee stock ownership plan (ESOP) to benefit petitioner’s employees. The ESOP then purchased from Dr. Elick all of the SDG stock. Dr. Elick served as SDG’s only officer and board member.
SDG was going to do all sorts of nifty things for Wiley M. Elick DDS, Inc (DDSInc):
SDG agreed to, among other things, produce annual capital, operating and cashflow budget plans; investigate and document in writing customer complaints; develop policies and procedures; recruit, supervise and train petitioner’s employees; perform fiscal services; and ensure regulatory compliance. Petitioner agreed in exchange to pay SDG management fees equal to between 1% and 25% of petitioner’s monthly gross receipts. Petitioner was obligated to pay SDG within 20 days of each month’s end. Dr. Elick executed the management agreement for both parties. Dr. Elick caused Surgitek to enter into a similar agreement with SDG.
Management Companies Need To Do Some
It was kind of hard for SDG to really do anything, because it did not have any employees. Dr. Elick entered into an agreement to be a “co-employee”, but that was it.
In 2005, DDSInc paid $430,000 in management fees to SDG and $303,000 in 2006. That was just shy of 10% of revenue. The problems was that there was nothing showing that SDG actually did anything
Petitioner failed to show that SDG rendered any services. In fact, petitioner offered no documentation reflecting that SDG performed any services for petitioner. SDG agreed to provide various services that petitioner never demonstrated it received, e.g., annual budget, operating and marketing plans. Further, petitioner acknowledged that third parties provided services SDG was to provide. In addition, petitioner never provided contemporaneous records corroborating it received any services.
Petitioner contends that the management agreement shows the services SDG purportedly provided. The management agreement, however, only indicates the services SDG agreed to perform. The management agreement does not demonstrate SDG performed any services benefiting petitioner. Petitioner never received monthly invoices the management agreement required. Nor did petitioner pay SDG monthly. The record reflects that petitioner and SDG disregarded most terms of the management agreement.
This is a rather nasty result, because it is not as if SDG does not still end up with the income. You cannot deduct payments for a corporation to do nothing, but if a corporation gets paid for doing nothing it is still taxable income. It could have been worse. In a 2012 case involving an accounting firm, the shareholders ended up with an imputed dividend.
Passive Activities
The couple also ran afoul of the passive activity loss rules. They had claimed losses from some flow-through entities which at trial they admitted to not having materially participated in. They tried a clever maneuver. They wanted to argue that Surgitek, which is a separate dental surgical center was a passive activity. That would have made for an interesting argument about the grouping rules of 469, but the Court ruled that the motion was untimely.
Moral
A lot of people believe that you can freely shift income between related entities as long as it ties out and you have not violated the “big balance sheet in the sky”. In reality, that kind of activity runs the risk of having you be whipsawed, because income is income, but deductions must be ordinary and necessary.