Expense Paid to Related Entity Found Not to Be Ordinary and Necessary, as Entity Claiming Deduction Did Not Receive Any Benefits

Taxpayers may form related entities for various purposes, some tax related and some not tax related.  But they may try and assign expenses between the various entities for reasons that don’t appear to have support based on the facts of the case, often in order to achieve a tax advantage.  But under the tax law a business deduction under IRC §162 is only allowed to an entity to the extent the expense represents an ordinary and necessary business expense of the entity claiming the deduction.

The Tax Court found that was not the case for certain expenses claimed in the case of Key Carpets, Inc. v. Commissioner, TC Memo 2016-30.

Key Carpets was owned by a married couple.  A year after its formation, the husband formed a second corporation, Clean Hands, of which he was the sole shareholder.  Initially it was meant to reserve the name for a hand washing system that was to be used in food handling facilities being developed by Key Carpets.  The system Key Carpets was working on would have used radio frequency identification tags (RFID tags) that an employee would present to the machine to record that the employee had washed his/her hands to document compliance with food handling rules.

Clean Hands was dormant for 11 eleven years.  During that time Key Carpets, which had hired five to six employees to attempt to develop this RFID machine.  Eventually the company determined that this machine was not feasible.

However another idea occurred to the husband—perhaps the better idea would be to develop a machine that was voice actuated.  Just before coming up with this idea he had hired an employee as a Clean Hands employee.  This employee was a computer technician who was to assist with the development of the hand washing machine.

Key Carpets paid Clean Hands $130,000 in 2007 and $128,222 in 2008, purportedly to develop the hand cleaning machine under contract with Key Carpets.  The IRS balked at these payments, arguing that, in fact, there was no evidence that Key Carpets actually had any ownership interest in the new hand washing machine.

The Tax Court agreed that the portion of the payment purportedly paid for the hand washing machine by Key Carpets was no deductible, as there was no evidence that Key Carpets had any rights in the new machine.

The Court noted:

Mr. Johnson did not present any credible evidence that Key Carpets owned the voice-activated hand washing monitoring system. His testimony that Key Carpets owned the voice-activated hand washing monitoring system was vague, unclear, and not credible. Mr. Johnson’s testimony contradicts his statements that he owned the patent on the voice-activated hand washing monitoring system. Additionally, the parties stipulated that Mr. Johnson was the sole owner of Clean Hands. Although Key Carpets had an ownership interest in the initial RFID badge-activated hand washing system, Key Carpets had no interest in the new voice-activated system that the computer technician developed as a Clean Hands employee. The Court therefore finds that Key Carpets did not own the voice-activated hand washing monitoring system.

…Mr. Johnson owned all the stock of Clean Hands, and he owned the patent on the voice-activated hand washing monitoring system. Key Carpets received no benefits from the payments for the development of the system. Therefore, the expenses were not ordinary and necessary. Key Carpets may not deduct the amounts paid to Clean Hands for the development of the voice-activated hand washing monitoring system.

The case points out a number of pitfalls that are easy for the client to fall into.  It is easy to see how the husband may have failed to realize that when he established multiple entities, he had to respect those specific entities.  A taxpayer can choose whatever form he wishes for his affairs, but once chosen he has to live with the consequences.

Likely the husband looked at Key Carpets, Clean Hands and himself as the same thing—so it did not “really” matter that he held the patent and that Clean Hands hired the employee.  He could “assign” the whole thing to Key Carpets, which likely could use the deduction while Clean Hands very likely had no income aside from that it received from Key Carpets—thus, any loss might be “useless” currently if it remained in that entity.