No Deduction Allowed for Payment to Related Entity When Reasonableness of Payment Not Demonstrated

Whenever taxpayers are paying for services between related entities the same interests control, the IRS is known to be skeptical of the reality of the arrangement.  The IRS questioned just such an arrangement in the case of Kauffman v. Commissioner, TC Memo 2017-38.

The taxpayer in this case was a realtor and cinematographer who operated several single member LLCs (all of which were treated as disregarded entities) and a C corporation.  The IRS was questioning payments made from one of the LLCs to the C corporation of $191, 000 for “consulting fees” and $75,000 in “commissions and fees.”

It turned out that the descriptions were not very clear about what was being paid for—the LLC was renting and using a sophisticated camera from the corporation.

There’s nothing inherently wrong with paying a controlled corporation for such items—but the fact that the transaction does not involve two unrelated parties, each looking out for that party’s interests, eliminates the market based check on reasonableness of the arrangement.  This complicates showing that the arrangement is truly an “ordinary and necessary” business expense that would be deductible under IRC §162 based on whether the amount being claimed is reasonable.

As the Court explains:

Even if an expense is ordinary and necessary, it is deductible under section 162 only to the extent it is reasonable in amount. United States v. Haskel Eng’g & Supply Co., 380 F.2d 786, 788-789 (9th Cir. 1967); Gill v. Commissioner, T.C. Memo. 1994-92, aff’d without published opinion, 76 F.3d 378 (6th Cir. 1996); Brallier v. Commissioner, T.C. Memo. 1986-42. The element of reasonableness is inherent in the phrase “ordinary and necessary” in section 162. Haskel Eng’g & Supply Co., 380 F.2d at 788-789.

The mere fact the payment was made does not mean it is reasonable, as the Court pointed out to Mr. Kauffman:

While petitioner explains on brief that the expenses were ordinary and necessary business expenses, he does not cite any credible testimony or other relevant evidence in the record supporting his assertion. The only evidence petitioner provided was accounting records and bank statements. However, these items merely reflect expenses allegedly incurred by RMH; the accounting records and bank statements do not show why the alleged expenses are ordinary and necessary. We also note that petitioner did not testify or offer other evidence explaining how the expenses were calculated or whether the corporation charged third parties the same amounts for similar services. Therefore, we are unable to determine whether the expenses were reasonable in amount. Consequently, on the basis of the record before us, we cannot find that the expenses were ordinary and necessary business expenses. We therefore sustain respondent’s determination on this issue.

As the opinion notes, when clients have different entities that they control that have transactions between them, the taxpayer will need to have more evidence than merely the accounting records.  Key will be the ability to demonstrate that the entity paying received something of value and that the payment made was in line with what would normally be charged in a transaction between unrelated parties.  As well, the use of vague terms like “consulting fees” or just “fees” will be more likely to raise suspicions about whether there is truly any real transaction taking place, or rather just a shifting of income between taxable entities to achieve some tax effect.