While taxpayers are not prohibited from structuring their businesses in the most tax-efficient manner possible, taxpayers who fail to adhere to the structure they choose may face hefty tax bills.  Last month, the Ninth Circuit, in Elick v. Commissioner, an unpublished opinion, affirmed the Tax Court's decision to deny a dental practice's payment of “management fees” to another company owned by one of the practice's shareholders.  The Tax Court's decision can be found at T.C. Memo 2013-139.

The taxpayers involved were Dr. and Mrs. Elick and his dental practice, Wiley M. Elick DDS, Inc., a C corporation.  Dr. Elick and his wife were the only shareholders of the dental practice. Dr. Elick was advised to set up an ESOP to benefit his employees.  In connection with establishing the ESOP, Dr. Elick was advised to establish a company to manage the dental company's operation.  The dental practice would pay the management company “management fees,” which would fund the ESOP.  Dr. Elick was the sole owner of the management company, SDG.  The ESOP then purchased all of Dr. Elick's SDG stock.  

SDG entered into an agreement to manage the dental practice.  Management activities included producing annual capital, operating and cashflow budget plans, investigating and documenting customer complaints, developing policies and procedures, and supervising and training the practice's employees. Dr. Elick signed the management agreement on behalf of SDG and the dental practice. The dental practice paid SDG nearly $750,000 in management fees in 2005 and 2006. 

SDG did not have any employees. Moreover, Dr. Elick failed to produce any evidence that SDG provided any management services.  The only evidence presented by Dr. Elick concerning the services provided was the management agreement itself.  The Tax Court disregarded Dr. Elick's self-serving testimony that he acted as an employee of SDG and found such testimony to be inconsistent with his full-time job as a dentist. Because there was no evidence that SDG provided management services, the Tax Court concluded that the management fees were not ordinary and necessary business expenses, and therefore were not deductible under section 162.

This case is an important reminder that business owners must adhere to the structure of the agreements that they enter into with related parties or entities; otherwise the IRS might come in with a big tax bill.  In addition, this case is yet another example of the importance of recordkeeping and documentation.  As we often see in IRS audits, the completeness of the taxpayer's records can make a huge difference when the taxpayer is trying to claim a deduction, or claiming material participation for purposes of the section 469 rules.