Factoring and management fees that four C corporations paid to their S corporation shareholders were not deductible expense. Rather, they were disguised distributions of corporate profits. Therefore, the distributions were taxable as constructive dividends or as income improperly assigned to the S corporations.
Five individuals had incorporated four C corporations and five S corporations formed into a partnership. The partnership extracted cash from the C corporations in the form of alleged “factoring fees” and “management fees.”
The C corporations deducted these payments, wiping out substantial portions of their taxable income. The partnership then distributed much of this cash to its S corporation partners. The partnership made the distributions to each S corporation ratably on the basis of the corresponding individual’s ownership interest in the C corporations.
Each individual received a salary from his S corporation, in whatever amount he believed necessary to support his anticipated living expenses. The individuals reported these amounts as taxable income. The S corporations retained the rest of the cash and, after paying certain expenses, invested it for the individuals’ benefit.
An employee stock ownership plan (ESOP) owned all of the stock of each S corporation. The individual who formed the S corporation was also the sole participant and beneficiary of its ESOP. Because the ESOPs were tax exempt, the partnership’s distributions to the S corporations, net of the owner’s salaries and benefits, were purportedly tax-exempt.
Thus, the transaction largely eliminated tax on the operating profits at the C corporation level, while indefinitely deferring any tax on those profits at the individual shareholder level.
The court accepted the expert’s opinion that the factoring arrangement between the partnership and the C corporations departed in many respects from arm’s-length factoring norms. The arrangement lacked economic substance because the five individual shareholders did not have a nontax business purpose for the transaction.
In addition, the factoring arrangement provided no meaningful working capital financing to the C corporations because they supplied the cash that enabled the partnership to “factor.”
Further, the annual percentage rate (APR) paid by the C corporations was not an arm’s length rate. Instead, it was at the high end of the range of APRs that independent factors would have charged.
However, the lack of formalities was not the main problem. Rather, the factoring scheme’s essential defect was that the C corporations paid a huge sum and received no meaningful economic benefit in return.
In addition, the IRS contended that the bonus payments that were part of the shareholders’ management fees were unreasonable compensation for services rendered. Thus, they were not deductible business expenses.
The court allowed the corporation’s to deduct bonus costs that were in the lowest quartile of similarly situated engineering firms. The court based its decision on the:
- absence of any structured bonus plan for the five individuals,
- existence of conflicts of interest, and
- clear intention to disguise nondeductible corporate distributions as salary expenditures.
Moreover, the IRS determined that the five principals received unreported income by virtue of the various corporate payments. The C corporations’ disguised expenses represented either compensation for the individuals’ services or distributions, and those amounts were either paid to them or held and invested for their future benefit.
The disallowed corporate expenses apportioned to the individuals exceeded the amounts of their unreported income. Therefore, four individuals received taxable constructive dividends equal to the amounts of unreported income that remained in dispute.
The fifth individual was taxable under the assignment-of-income doctrine on unreported income because his S corporation could not direct or control in some meaningful sense the activities of the service provider.