Dental practice couldn’t deduct “management fees” where no services were performed

The Tax Court, upholding IRS, has determined that a dental practice wasn’t entitled to deduct purported management fees paid to a related entity. The fees weren’t ordinary and necessary where there was no indication that the entity actually performed any services in exchange for the fees.

Generally, a taxpayer may deduct ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business.  An expense is ordinary if it is customary or usual within a particular trade, business or industry or relates to a common or frequent transaction in the type of business involved. A necessary expense is appropriate and helpful to the operation of the taxpayer’s trade or business.

The Case

Wiley M. Elick DDS, Inc. is a dental practice (the practice). Dr. and Mrs. Elick are the practice’s sole shareholders and board members, and they are also both salaried employees. The practice also employed a bookkeeper/office manager who was paid a salary. In addition to the practice, Dr. Elick also owned and operated Surgitek Outpatient Center, Inc. (Surgitek), an adjacent dental surgery facility.

Dr. Elick, acting upon the advice of a professional, established a company to manage the practice’s operations. He became the owner of an existing corporation, SD Management Group, Inc. (SDG), which established an employee stock ownership plan (ESOP) to benefit the practice’s employees. The ESOP then purchased from Dr. Elick all of the SDG stock. Dr. Elick was SDG’s only officer and board member.

SDG then entered into a management agreement to manage the practice’s operations, agreeing to: produce annual capital, operating and cashflow budget plans; investigate and document in writing customer complaints; develop policies and procedures; recruit, supervise, and train the practice’s employees; perform fiscal services; and ensure regulatory compliance. In exchange, the practice agreed to pay SDG management fees ranging from 1% to 25% of its monthly gross receipts within 20 days of month-end. Surgitek entered a similar agreement. SDG had no paid employees during 2005 and 2006. Dr. Elick entered into an employment agreement to be a “co-employee” of both the practice and SDG.

Dr. Elick practiced dentistry full-time for the practice during 2005 and 2006, and the bookkeeper continued to work full-time and performed many of the functions that SDG was to provide. The practice paid SDG management fees of $430,000 for 2005 (9.76% of its annual gross receipts) and $303,000 for 2006 (9.98% of its annual gross receipts). These amounts were determined by Dr. Elick. Surgitek paid SDG $20,000 in 2005 and nothing in 2006.

On its Forms 1120 for 2005 and 2006, the practice claimed business expense deductions for the management fees. Dr. Elick told the return preparer the amounts paid, and the preparer didn’t verify the accuracy of the numbers or review any related documents. On their jointly filed Forms 1040, the Elicks reported ordinary business losses from three LLCs and ordinary income from Surgitek. Their 2006 return was filed well past the deadline.

IRS issued deficiency notices to the practice disallowing the management fee deductions and imposing accuracy-related penalties, and to the Elicks disallowing their claimed losses  and imposing accuracy-related penalties and late-filing additions to tax for the 2006 return. The Elicks filed a Tax Court petition alleging that the claimed losses weren’t subject to the passive loss limitations because they materially participated, then later sought to amend their petition to allege that Surgitek was a passive activity, the income from which was offset by the losses. The motion to amend was denied as untimely.

The Decision

Management fees aren’t deductible. The Tax Court found that the management fees were unnecessary in this case because, although SDG agreed to provide various management services, there was no proof that it actually did so. Notably, the practice actually hired third parties to provide certain of the services that SDG had agreed to provide, and it also never provided any records corroborating that it received any services. Dr. Elick’s claim that he was a “co-employee” was undermined by the facts that he was a full-time employee of the practice and that he never received any compensation for his purported services. There was also no indication that the services performed by the practice by the bookkeeper were performed as an employee of SDG. Accordingly, IRS’s disallowance of the management fee deductions was upheld.

The Tax Court also agreed with IRS that the Elicks’ claimed losses from the LLCs were subject to the passive loss limitations of Code Sec. 469. They alleged in their petition that they met the material participation requirements, but then acknowledged that they didn’t actively participate and should be permitted to offset the losses against their income from Surgitek, which they now claimed was incorrectly characterized as an active activity. The Court had denied the Elicks’ untimely request to amend their petition, and it now held that they were precluded from offsetting the claimed losses against their Surgitek income. Accordingly, IRS’s determination that they weren’t entitled to the claimed business losses  was sustained.

If you have any questions regarding this case or the impact to your related party entities, please do not hesitate to contact us.

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