A main reason why people create a business is Code Sec. 162(a), which allows a taxpayer to deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business. An expense is ordinary if it is normal or customary within a particular trade. For my real estate investor clients such an expense might be travelling around to look at real estate opportunities or obtaining education to expand their investing knowledge. Any expense can be considered necessary if it is helpful for the development of the business.
So why the background information on Code Sec. 162? Because many small business owners sometimes forget that reasonableness is inherent in the phrase “ordinary and necessary.” I will often joke with people when discussing possible tax deductions that if the through of writing something off as a business expense brings a smirk to your lips you probably shouldn’t. (This is known as the giggle test, i.e., if you find it funny the IRS will not.)
For the small business owner, the reasonableness concept has particular significance when dealing with management fees, rents, consulting fees, etc. between commonly controlled business entities. Do these payments represent ordinary and necessary expenses? In a recent Tax Court case this was at issue when a taxpayer was denied the ability to deduct management fees, in amounts greater than IRS allowed, that his single-member limited liability company (LLC) paid to his wholly owned C corporation.
In this case, the taxpayer’s LLC paid his C corporation (classic income shifting strategy to reduce tax at the individual level and move it into a corporation where he can find additional deduction) a monthly consulting fee of $9,000. (Note: the taxpayer claimed this as an “other expense” on his tax return e.g., $96,000 a red flag for any auditor.) When audited the taxpayer could not establish how the monthly fee were determined, provide a written contract, produce a detailed invoice or provide an evidence of special skills that might warrant the consulting fees. Essentially the taxpayer thought all he had to do was set up a C corporation and begin charging his LLC a monthly fee. The court disagreed and the taxpayer’s management fee was reduced by 60% on audit.
For the real estate investor or small business owner who would like to utilize a management company for tax savings this case should serve as a warning that the details matter. I run into many people who believe entity planning can be accomplished by reading a book, listening to a lecture, then filing a few entities with the state and everything will be roses. For many it usually is until an audit or lawsuit develops and then you will discover what it is you don’t know.