Paying Management Fees from one of your Businesses? Beware the Tax Rules
A recent Tax Court case (Little Mountain Corporation v. Commissioner) had to deal with a family that owned several different businesses (with common ownership). These businesses had relationships with each other such that there were instances where one business paid another business a fee for “consulting.” The Court had to determine if the tax deductions claimed for the consulting fees were deductible. It determined that they were not.
It is important to remember that in order to deduct any business expense, it must be demonstrated that the expense was:
In this case, there were no written contracts to account for the $896,493 deducted for consulting services. There were invoices that showed that the amounts were due for “consulting, writing, and managerial fees”, but did not detail what services were performed. The invoices requested that any payments be issued in amounts less than $10,000 and be made payable in “cash”. The checks were then cashed by various individuals.
At trial, Little Mountain provided no documents or testimony regarding how the consulting fees were determined. It provided no consulting fee schedule, hourly rate, or specific breakdown of what the consultants actually did. In addition, no witness could testify with any specificity as to what services were performed to support the consulting fees. No one could account for why the checks were issued (only vague statements concerning “consulting”). There were no written contracts for the consulting fees, and Little Mountain never issued any Forms 1099.
The Tax Court noted that the case involved the strange situation of a corporation that claimed to have no employees and no written contracts with any independent contractors, issued no Forms 1099 to any independent contractors, and enjoyed enormous amounts of income during the tax year in issue without paying any dividends to its shareholders. The Court had no trouble ruling in favor of the IRS.
The lesson: The taxpayer in this Little Mountain case could have prevailed had it done the following:
· Always use a written contract
· Always provide itemized invoices showing the services performed and the amount charged
· Do not base the payment on the business’ profit, but instead make the sure that the payment is rendered based upon any hourly or other agreed compensation rate
· Keep track of all work performed
· Always pay by check/bank transfer (for a written confirmation of the transaction)
· Always issue Forms 1099, W-2 or any other forms to support that the payments were made
· Treat these expenses (those between entities that are owned/controlled by one or more related persons) as you would any other expenses.
· Keep accurate books and records to show when the payments were made, for what reason and to whom