MANAGEMENT ENTITIES

Taxpayers who own various business entities often establish a management entity to provide management services to the entities and/or to act as a common paymaster and employer of all the various entities. The operating businesses will pay a fee to the management entity for the services provided, which fee will usually include an element for reimbursement of the hard costs of the management entity such as for employee wages and withholding taxes.

A recent Tax Court case challenged the deductions claimed by the operating entity for its payments to the management entity. The case addressed a number of the tax issues involved in these arrangements, and provides many “lessons” in structuring them. Some of the key lessons are described below.

1. WHEN WILL THE IRS ATTACK? The IRS will generally be interested in attacking these arrangements only when it perceives taxes are being deferred or avoided. Oftentimes, there are no deferral or avoidance circumstances. For instances, if the operating entities and the management entity are commonly owned, and are pass-through entities such as LLC’s, partnerships or S corporations, the deduction on the operations side is offset by the income on the management entity side. Even with C corporations, if both the operations side and the management side are profitable, then there is little chance of tax avoidance. In the instant case, the operating entity and the management entity were both S corporations. However, the management entity was owned by an ESOP. Thus, there was not common ownership on both sides. Further, the ESOP allowed for deferral or avoidance of tax on the management fees earned by the management entity, while the payor operating entity received an operating deduction. Thus, the IRS was very interested in challenging the management fees.

2. WILL THE MANAGEMENT ENTITY BE DISREGARDED AS A SHAM ENTITY? Relying on Moline Props., Inc. v. Commissioner, 319 U.S. 436 [30 AFTR 1291] (1943), in the instant case the IRS argued that the management entity should be disregarded for Federal income tax purposes because it lacked a legitimate business purpose and economic substance and was formed for the sole purpose of obtaining tax benefits. Such an attack can be successfully defended if the taxpayer can show the management entity was formed for a valid business purpose or if it actually engaged in business activity. Some business purposes that often exist in these circumstances (and that should be of assistance in defending a Moline-type attack) include:

a. Centralization of employee management;

b. Provision of management and other actual services;

c. Creditor protection (including products liability protection) by placing management in an entity without significant business assets and separating business activities in multiple entities;

d. Establishment of incentive and retirement plans for employees; and

e. Business efficiencies via centralization of services and activities.

In the instant case, while the taxpayer had difficulty factually proving a valid business purpose for the arrangement, it did conduct enough actual business activities to avoid a sham finding. In particular, the Tax Court noted that the management entity provided personnel services, maintained an investment and bank account, paid employees by check, adopted a retirement plan, followed corporate formalities and filed income and employment tax returns.

3. WILL MANAGEMENT FEES BE DEDUCTIBLE? Code §162 requires that expenses be ordinary and necessary in carrying on a trade or business to be deductible. Presumably, if the management entities provide employees to the operating entities, fees paid for such employees will be ordinary and necessary and deductible – this is what occurred in the subject case and was approved by the Tax Court. However, in the subject case, the IRS successfully challenged the management fees paid for other services. To enhance the deduction for such services, the following items are helpful:

a. Have an agreement to establish what services will be performed and what will be paid for them; and

b. Make sure the services are in fact performed by the management entity, and be able to specifically prove what was done (this was a problem in the subject case).

Overcharging or undercharging for fees can be problematic, either under Code §162 requirements of a “reasonable” amount, or Code §482 which requires amounts paid between commonly controlled entities to meet arms-length standards.

4. LOANS. If loans exist between the entities, adequate interest should be charged – if not, the IRS will typically be able to impute interest under Code §§482 and/or 7872. Code §7872 was applied in the subject case. All loans should be documented and treated as such on the books and records – failure to do so could result in deemed distributions and dividends.

On the positive side, the Tax Court had no problem with the concept of a management entity or centralized employer – so long as the parties toe the line on the above issues.

Weekend Warriors Trailers, Inc. v. Comm., TC Memo 2011-105

HOMESTEAD WAIVER CASE WITHDRAWN [FLORIDA]

On March 19, 2010, I commented on the Habeeb case. In that case, a Florida appellate court ruled that the entry of a spouse into a deed that transferred the spouse's ownership interest in a homestead to the other spouse was sufficient for that spouse to waive his remaining homestead rights in the property.

I commented that for various reasons, this appeared to be a questionable conclusion, due to Florida requirements for written waivers of homestead rights and fair disclosure of assets for a valid waiver.

The Habeeb opinion has now been withdrawn. Perhaps for the reasons I mentioned, perhaps for other reasons. Until a subsequent opinion is issued, or some other court addresses a similar issue, things are now back to where they were before the Habeeb case.

ARE YOU CHECKING FOR DOCUMENTARY STAMP TAXES ON TRANSFER OF ENTITY INTERESTS [FLORIDA]?

Florida recently issued emergency rules relating to the imposition of documentary stamp taxes on the transfer of conduit entity interests. The rules do not greatly expand on the statutory rules, but are a useful reminder of the broad reach of the conduit rules. I would wager a significant sum that there are many transactional attorneys and business persons that are not routinely reviewing the potential application of Florida documentary stamp taxes on the transfer of interests in corporations, partnerships, LLC’s, and other entities.

Florida imposes documentary stamp taxes at the rate of $0.70 per $100 of consideration paid for Florida real property. Some counties impose an additional surtax. In recent years, Florida law has developed to allow or acknowledge that oftentimes real property can be transferred to an entity without incurring the tax. This has opened the door to planning whereby taxpayers would transfer real property free of tax to an entity, and then sell the entity to a third party buyer (instead of selling the real property directly) to avoid documentary stamp taxes on that sale.

In 2009, Florida sought to close the door on this type of planning. It revised Fla.Stats. §201.02 to impose tax on transfers of interests in “conduit entities.” Generally, a tax will be imposed if (a) real property is conveyed to a conduit entity, (b) within 3 years of the conveyance, and (c) all or a portion of the grantor's direct or indirect ownership interest in the conduit entity is subsequently transferred for consideration. If the entity owns assets other than real property, then the tax will be prorated. A “conduit entity” is a legal entity to which real property is conveyed without full consideration by a grantor who owns a direct or indirect interest in the entity, or a successor entity.

Exceptions exist. Transfers of interests in a conduit entity that are in the nature of a gift (that is, they are without consideration), are not taxable. Transfers of interests in publicly traded entities are also exempt. A transfer of an interest to an irrevocable grantor trust is exempt – this appears directed at exempting sales to defective grantor trusts. A transfer of an entity interest at death generally should not be subject to tax since there is usually an absence of consideration paid.

The new emergency rules clarify that if the transfer to the entity was subject to documentary stamp taxes, then the transfer of the interest in the entity is not taxable as to that real property. They also have an example that makes clear that the buyer of an interest in the conduit entity will not be subject to tax on a subsequent resale of that interest, since the buyer was not the original “grantor.” The rules also provide that that tax is due on the earliest of the 20th day of the month following the month the ownership interest is transferred or the date that an instrument evidencing the transfer is filed or recorded in Florida.

Thus, any time there is a transfer of an interest in any nonpubicly traded entity for consideration, the question needs to be asked if Florida real property was transferred to it within 3 years by the seller (including indirect transfers through entities). This is similar to another set of tax rules that can relate to transfers of entities that is often overlooked – Code §1445 withholding on dispositions by foreign persons of interests in entities that are U.S. real property interests by reason of ownership of U.S. real property.

Florida Administrative Code §12BER11-2 (May 13, 2011)