For various reasons CPAs run into clients who have established several related taxable entities that have interactions with each other. And, quite often, this multiplicity of entities creates problems where one entity has “excess” deductions while the other has an excess of income. In the case of Home Team Transition Management v. Commissioner, TC Memo 2017-51 the IRS questioned the propriety of a deduction for “management fees” paid by the profitable entity to the corporation which held its shares.
In this case the holding company was Sacer Cor Enterprises which had reported receiving fees from Home Team Transition Management, the defendant in this case. The Court outlined how Sacer Cor ended up being the owner of Home Team Transition Management:
Sacer Cor is a Missouri for-profit corporation that was incorporated by Charles N. Honigfort. Sacer Cor’s shares were held in equal percentages by Charles and Mary Honigfort and Sean and Ruth Ann Noonan. When Sacer Cor was incorporated, it was the intention of the four shareholders to acquire in-home healthcare companies. On October 1, 2010, Sacer Cor acquired petitioner, which had been an ongoing business since 1994 and had the same four shareholders (owners) as Sacer Cor. When the owners acquired petitioner, it was owned and operated by an individual who lived in New York State and had an existing contract with Medicaid. During 2011 through 2013 petitioner was Sacer Cor’s only holding and no other healthcare companies were acquired.
The taxpayer corporation in this case had claimed deductions in 2011-2013 for management fees of $120,000, $36,000, and $42,000. In each year, Home Team had transferred funds to Sacer Cor as it had cash available to transfer, and the funds were initially recorded as loans to Sacer Cor. At the end of the year, some or all of the loans were reclassified as management fees.
The Court noted that the fees were based solely on Home Team’s ability to pay rather than being payments for specifically invoiced services. Also, Sacer Cor had no employees for the years in question, although two of the Sacer Cor shareholders were employees of Home Team and were paid a salary by that organization. The Court noted that Home Team did not produce any evidence of any services provided by Sacer Cor.
To claim a deduction for these fees the Court noted that under Section 162 the taxpayer must show:
- The payments were for services actually performed;
- The services performed represented ordinary and necessary expenses of the business itself and
- The payments were reasonable for the services performed.
When related parties are involved, the Court has a natural skepticism about the true nature of the payments, a skepticism that generally must be overcome by showing evidence that establishes the arrangement is one that could be reasonably have been entered into by unrelated parties.
In this case, the taxpayers failed to carry any of the burdens to show that the payments were ordinary and necessary payments for services under Section 162. An unrelated third party would be unlikely to agree to be paid for services based solely on the company’s available cash, and the company wouldn’t be likely to agree to make such payments of available cash to a non-owner—however, such an arrangement does make sense to make dividend payments to a shareholder.
Similarly, Sacer Cor had no employees who would have been available to perform any management services, nor were there any records of exactly what “management services” were the responsibility of Sacer Cor. Rather, the funds simply went to the holding company that then turned around and paid out director fees to its four shareholders.
It is possible to have payments made to a related company that survive scrutiny—we discussed such a case back in May of 2016 (H.W. Johnson, Inc. v. Commissioner, TC Memo 2016-95) where administrative fees (a close relative of “management fees”) were found to be reasonable. But in that case, unlike this one, there was a clear business reason for the existence of the related entity and a solid business justification for paying that organization (the related organization, owned by the minority shareholders, took on substantial risks the majority shareholder did not want to take on).