United States

Tax Court recharacterizes management fees as constructive distribution

TAX ALERT  | 

The Tax Court in Pacific Management Group et al. v. Commissioner, T.C. Memo. 2018-131, held that taxpayers who reorganized their businesses in an attempt to defer tax on undistributed income had in fact made constructive taxable distributions to their shareholders. Although the details of the case are complicated, involving C corporations, S corporations, partnerships, and employee stock ownership plans (ESOPs), the decision highlights an important principle – courts may look skeptically upon certain restructurings, particularly those that create entities that conduct little or no business activity, and that appear to be employed solely to generate a tax benefit that the taxpayer wouldn’t otherwise enjoy.

As such, taxpayers considering restructurings need to pay careful attention to the details to help ensure that they will be respected.

The Facts

Although the facts in the case are complex, they can be summarized as follows. Five individuals worked for and owned varying interests in several C corporations. The individuals appear to have historically received cash – whether in the form of wages or as dividends – from the corporations to defray their personal living expenses. The shareholders were interested, however, in deferring tax on earnings in excess of that needed for those living expenses.

In an effort to accomplish this goal, the shareholders engaged an outside adviser who suggested that they form several new entities with the intention of shifting the incidence of tax on these excess earnings from the C corporations. The plan involved organizing a partnership that would charge each of the C corporations a management fee and an accounts receivable factoring fee. Those charges would strip most of the income from the C corporations.

The partnership in turn would distribute its earnings to its owners – five S corporations that in turn were owned by ESOPs whose beneficiaries were those same five shareholders. The individuals still received wages from their respective S corporation in an amounts sufficient to defray their living expenses, but the S corporations retained excess amounts and escaped current tax by virtue of the tax-exempt owner (the ESOP).

The Issues

The taxpayers’ mechanism for extracting earnings from the C corporations were these new management fees and the factoring fees that the partnership charged the C corporations. The issue facing the court was whether it should respect those transactions and the related fees, or if instead those transactions lacked substance (either in whole or in part) and instead should be recharacterized as disguised distributions from the C corporations to their owners.

The Conclusion

The court separately analyzed the substance of the factoring fees and the management fees, ultimately expressing concerns with both.

With the factoring fees, the court leaned on testimony that suggested that the factoring arrangement lacked many of the characteristics that one would expect in an arm’s length arrangement. In addition, the economic return that the partnership was earning for these purported services were far in excess of what was typical in the industry. As such, the court concluded that the factoring arrangement had no economic substance. The court explained, “In an objective sense, [the factoring arrangement] provided no economic benefit to the [companies] beyond the tax benefits they hoped to achieve by disguising as deductible payments what were actually distributions of corporate profits. . . . In a subjective sense, the arrangement lacked economic substance because the five principals had no non-tax business purpose for the transaction.” As such, the court recharacterized the factoring fees as constructive distributions.

The court took a slightly different approach with the management fees – focusing instead on whether they were reasonable based on the services provided. In its analysis, the court analyzed the facts against five factors on which the Court of Appeals for the Ninth Circuit (the likely appellate venue for the case) traditionally has relied:

  1. the service provider’s role in the company,
  2. a comparison of the service provider’s salary with salaries paid by similar companies for similar services,
  3. the character and condition of the company,
  4. potential conflicts of interest, and
  5. the internal consistency of the company's compensation arrangement.

The court concluded that the fees were excessive based on industry standards and recharacterized a portion of those payments as constructive distributions by the C corporations to their shareholders.   

Implications

The Tax Court analyzed the techniques employed by these taxpayers – the factoring fees and the management fees - against objective and subjective criteria. In addition and importantly, the court noted that the new partnerships and S corporations that were formed to execute this strategy were essentially “paper entities.” Neither the partnership nor the S corporations performed any management services for the C corporations. Similarly, their activities with respect to the factoring arrangement appears to have been negligible.

The court’s skepticism regarding the economic substance of arrangements such as these – particularly where an existing entity tries to reorganize to generate a tax benefit that did not exist previously – is a good reminder for taxpayers. Companies considering restructuring transactions should be sure that their arrangements are supportable based on arms-length standards. This reminder is particularly timely in light of entity choice analyses that many taxpayers are conducting because of recently enacted tax reform legislation.

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