Weekend Warrior entered into a management agreement whereby Weekend Warrior would pay $4,175,000 during year 1 to Leading Edge to perform accounting, marketing, sales and purchasing, human resources, and product research and development functions for Weekend Warrior.
Upon audit, the IRS disallowed Weekend Warrior’s management fee expense. The Service argued that Leading Edge was a sham corporation and should be disregarded, as it had neither economic purpose nor substance, as its sole purpose was to provide a deduction to Weekend Warrior, reducing Weekend Warrior’s taxable C corporation income.
The Tax Court, disagreed with this contention, however, providing:
Leading Edge provided personnel services to Weekend Warrior. It maintained an investment account and bank accounts. It paid its employees by check, adopted a retirement plan, which respondent does not timely argue was a sham, kept books and records, and engaged Mr. Baily to appraise its stock. Leading Edge invested excess funds and at least from August 2003 through December 2004 purchased and sold stocks and received dividends. Corporate formalities were followed. Leading Edge filed Federal income tax and employment tax returns. We conclude Leading Edge carried on sufficient business activity to be recognized for Federal income tax purposes.
Undeterred, the IRS also argued that the management fee should be disallowed on the grounds that it was not an “ordinary and necessary” business expense of Weekend Warrior. On this position, the Tax Court agreed, denying Weekend Warrior’s $4,175,000 deduction based on the following:
Whether the fees were reasonable and necessary depends on what services Leading Edge actually performed (as opposed to what the management agreement provided it would perform). The record, however, is sparse as to the details of the parties’ actual relationship. Leading Edge issued no invoices to Weekend Warrior for 2003 and 2004. Of the four invoices that Leading Edge issued for 2002, two predate the incorporation of Leading Edge, raising questions regarding the genuineness of the other two invoices as well. The invoices contain only a general description “Management Fee”. The record is also sparse regarding the identity of the persons who allegedly supplied services on behalf of Leading Edge under the management agreement. Because the record is vague as to what specific services Leading Edge performed for Weekend Warrior under the management agreement and who exactly performed those services, we cannot conclude that the fees for those undefined and unquantified services were necessary or reasonable.
The lesson is obvious. As prior case law dictates, a taxpayer may adopt any form he desires for the conduct of his business and the chosen form cannot be ignored merely because it results in a tax savings. However, an entity must have a valid business and economic purpose, and arrangements between entities must be formalized and real. As practitioners, we often concern ourselves with whether a party is paying a discounted amount in a non-arms length transaction. As Weekend Warrior points out, we must be equally cognizant of whether the service provider is holding up their end of the bargain; providing a level of service that justifies the payment received.