In another recent case involving a multi-entity tax savings strategy, pitched as the “integrated tax plan,” particularly leveraging “management fees,” we see again the Tax Court scrutinizing the legitimacy of the structure, incorporating a C corporation and a partnership, and in turn allowing the IRS to whipsaw the taxpayers.[1]
Facts
Around late 2009 through early 2010, Frank Berrito and Dana Berrito (now deceased) hired A. V. Arias & Co. to prepare an “integrated tax plan” involving the setup of a C corporation and a partnership, Fab Holdings, LLC (“Fab”) and Berrito Enterprises, LLC (“Enterprises”), respectively, to manage certain investments of the Berritos. Specifically, it appears that Enterprises held the assets and Fab was the designated entity to act and receive compensation pursuant to a management agreement between the two. In turn, being a partnership for tax purposes, Enterprises was able to flow out nonpassive losses which were reported on the Berrito’s individual return. Fab reported its income, being derived from the management of Enterprises.
The Tax Court noted that Enterprises’ income was mostly comprised of interest, dividends, and capital gains from securities investments contributed by Mr. Berrito. Mr. and Mrs. Berrito each owned 50% of each entity. Throughout the year, Enterprises would pay fees, such as management fees or bonuses, to Fab, deducting those as an expense. Conveniently, Fab had a fiscal year ending on March 31 while Enterprises was a calendar year taxpayer, thus punting taxable income for one year into the next, effectively. The years at issue were 2011-2014 for Fab and 2010-2013 for the Berritos.
During the years at issue, Enterprises would earn money from its investments, yet pay a large management fees and performance bonuses to Fab, reporting ordinary business losses as a result. Fab would, in the following year due to offsetting reporting dates, report its income and deductions which included legal fees, employee benefit plan expenses (medical reimbursements and long-term care insurance), some wages, and directors’ fees.
During the audit, Mr. Berrito and Mrs. Berrito’s estate, through Mr. Berrito, as executor, engaged Arias again to represent them. During the process, Arias signed three Form 872’s as Fab’s representative, agreeing to extend the statute of limitations for assessment of tax. Finally, on July 26, 2017, the IRS mailed the notices of deficiency for the returns at issue. The adjustments made were (1) adjustments to Enterprises’ and Fab’s expense deductions, (2) constructive dividends to the Berritos from Fab, and (3) penalties.
The Elephant in the Room
The major item affecting the Berritos personally was the denial of deductions for the management expenses and performance bonuses paid to Fab. Additionally, there was an assessment of a constructive dividend from Fab to the Berritos for approximately $200,000, over the time at issue. With respect to Fab, certain salaries, professional expenses, benefit programs, and directors’ fees were recharacterized as constructive dividends. Further, while deductions were disallowed Enterprises, there was no adjustment to income for Fab, thus giving the result a whipsaw effect.
Brief Discussion of Promoter Issues Raised
There was an attempt to disqualify and nullify Arias’ actions, agreeing to the statute extensions, due to being a promoter having a conflict of interest. The Tax Court did not have it. Throwing a lot on the wall, nothing seemed to stick for the taxpayers. The Tax Court concluded that just because a professional is paid to help a taxpayer with a tax-efficient structure or transaction, that alone does not make that person a promoter or disqualify them for having a conflict of interest.
The Correlative Adjustment and the Tax Court’s Discussion of the Use of the C corporation
To start, the taxpayers did not dispute the disallowance of the management fees and performance bonuses. Instead, they took issue with the fact that the items were disallowed such that Enterprises, and subsequently the Berritos, lost the deductions while Fab, who paid tax on that income from a disallowed Enterprises’ expense, was stuck with its tax bill. The taxpayers argued that the IRS should have made a correlative adjustment to Fab’s income for the disallowed partnership items. As a result of there being no adjustment, the taxpayers argued that the Berritos would be double taxed unfairly.
The Berritos sought to analogize their case to Alondra Indus., Ltd. V. Comm’r, (T.C. Memo 1996-32), where correlative adjustments were made with respect to related entities, consisting of corporations and a partnership. The Tax Court found the case distinguishable due to ownership variances. In Alondra, the Tax Court stated there was a direct flow-through impact. Here, the buck literally stopped with a C corporation, an entity that had no flow-through characteristics and was instead a separate taxpayer. In a single line, the Tax Court put it bluntly, citing a previous case, saying “In structuring their business as a separate taxable entity, shareholders consider whether ‘there was some benefit in doing business through a corporation. They must accept the liabilities as well as the benefits.’”[2] Additionally, the Tax Court stated “While a taxpayer is free to organize his affairs as he chooses, nevertheless, once having done so, he must accept the tax consequences of his choice[.]”[3]
Unfortunately, since the Berritos chose a C corporation, they got the benefit of their selection. The Tax Court ultimately held that the IRS was not obligated to make a correlative adjustment. The result was a whipsaw for the Berritos.
Constructive Dividends
The taxpayers argued against the constructive dividend treatment for the items previously mentioned. The Tax Court held that each of the items listed, save for the directors’ fees were constructive dividends. A constructive dividend arises “[w]here a corporation confers an economic benefit on a shareholder without the expectation of repayment even though neither the corporation nor the shareholder intended a dividend.”[4] Citing back to their correlative adjustment request, the Berritos wanted Fab’s income reduced too, thus reducing its earnings and profits and potentially allowing them to recover some basis, thus lowering their tax. Unfortunately, the taxpayers were unable to meet the burden of proof and consequently the IRS won on the issue, except as to the directors’ fees which the Tax Court determined they already paid tax on, as a benefit received from the corporation.
Conclusion
Here, the taxpayers did not win. We have seen similar types of structures before.[5] Unfortunately, many of the C corporation, management company structures fail as taxpayers are often unable to prove that they were a distinct, legitimate, and separate business. When the taxpayers fail, a whipsaw effect can occur because the C corporation is a separate taxpayer. Here, taxpayers should be cautioned on special and complex arrangements between related entities, created solely for the reduction of tax. Also, please do not call it the “tax plan.”
[1] Fab Holdings, LLC, et. al. v. Comm’r, T.C. Memo 2021-135.
[2] See Noble v. Comm’r, 368 F.2d 439, 445 (9th Cir. 196).
[3] See Comm’r v. Nat’l Alfalfa Dehydrating & Milling Co.,417 U.S. 134, 149 (1974).
[4] See Hood v. Comm’r, 115 T.C. 172, 179 (2000).
[5] See Blossom Day Care Centers – The Income Tax Side, Joshua W. Sage, J.D., LL.M. (Aug. 3, 2021).
