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Lessons from the Tax Court: Tax drill for management fees

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in Small Business Tax,Small Business Tax Deduction Strategies

Under Section 162 of the tax code, your business can deduct a wide range of “ordinary and necessary” business expenses. This may include bona fide business management fees paid to professionals or a management firm used for this purpose. But you can’t deduct expenses just because you’ve labeled them as “management fees.”

In a new case, the Tax Court determined that such an arrangement was a sham and denied the taxpayer any deductions.

Facts of the new case: A dentist, who was the sole shareholder of his professional corporation (PC), used a bookkeeper and an outside payroll service for the PC. All of the stock in the PC was owned by an employee stock ownership plan (ESOP). Then the ­dentist set up another corporation to manage his ­practice.

The new corporation was purportedly responsible for providing annual financial reports, investigating patient complaints, developing employment policies and procedures, recruiting and training employees and complying with various requirements. The dentist arranged to pay between 1% and 25% of his monthly gross receipts from the practice to the corporation. During the tax years in question, he paid management fees of $430,000 and $303,000. These amounts were deducted in full by the PC.

But the IRS objected and the Tax Court sided with the IRS. Reason: Although management fees may be deductible as business expenses, the fees weren’t “ordinary and necessary” in this instance. The management corporation had no employees of its own, while it only employed the dentist and his bookkeeper as co-employees. Essentially, the corporation did nothing for the practice (other than codifying the co-employment agreement with the dentist).

In other words, the Tax Court viewed the arrangement as a ploy to create income for the ESOP, to the tax benefit of the dentist. Case closed: No deduction was allowed. (Elick, TC Memo 2013-139)

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