Great case.  This shows the need for appropriate documentation, and that a business must in fact be a business and not a sham.  It also follows the pigs get fat hogs get slaughtered rule.  I recommend avoiding the unfortunate mistakes made by these individuals, and using a management company to actually perform real business services that are appropriately documented, and with fees commensurate with the services actually rendered.  When you do it right, it works.  Stories about people falling off of bicycles and getting hurt because they were not being safe does not mean bicycles don't work.

here is the case for the article:

SUPREME COURT WON'T REVIEW CASE ON DEDUCTIBILITY OF DENTAL PRACTICE'S MANAGEMENT FEES

Elick v. Comm., (CA 9 1/6/2016) 116 AFTR 2d 2016-457116 AFTR 2d 2016-457, cert denied 5/16/2016

The Supreme Court has declined to review a decision of the Court of Appeals for the Ninth Circuit that denied a dental practice's claimed deduction for purported management fees paid to a related entity. The Ninth Circuit concluded that the fees weren't ordinary and necessary within the meaning of Code Sec. 162 and that there was no indication that the entity actually performed any services in exchange for the fees.

Background. Generally, a taxpayer may deduct ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business. (Code Sec. 162(a)) 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 deduction of passive activity losses is generally suspended under Code Sec. 469(a). Passive activity losses are the excess of all aggregate losses from passive activities over the aggregate income from all passive activities for the tax year. (Code Sec. 469(d)(1)) A passive activity includes the conduct of any trade or business in which the taxpayer does not materially participate.

Facts. Wiley M. Elick DDS, Inc. was a dental practice (the practice). Dr. and Mrs. Elick were the practice's sole shareholders and board members, and they were 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 entered into a management agreement to manage the practice's operations, agreeing to: produce annual capital, operating and cash flow 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 under Code Sec. 469 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.

Tax Court decision. The Tax Court upheld IRS's disallowance of the management fee deductions. The Court found that the management fees were unnecessary 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 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. (Elick, TC Memo 2013-139TC Memo 2013-139, see Weekly Alert ¶ 13 06/13/2013)

The Tax Court also found that the Elicks' claimed losses from the LLCs were subject to the passive loss limitations of Code Sec. 469. In their petition, the Elicks alleged that they met the material participation requirements, but then acknowledged that they didn't actively participate. When the Elicks claimed that they should be permitted to offset the losses against their income from Surgitek—which they claimed was incorrectly characterized as an active activity—the Court denied their untimely request to amend their petition. It held that they were precluded from offsetting the claimed losses against their Surgitek income.

The Court also upheld IRS's imposition of accuracy-related penalties against the practice for tax years 2004 - 2006, and against the Elicks for 2005 and 2006. It found that the practice didn't make a reasonable attempt to comply with the Code, in that it failed to provide credible evidence that it received services for the management fees or show that it respected the terms of the management agreement. The fact that the overall structure was suggested by a professional was insufficient to establish reasonable cause where the professional didn't review the returns at issue. The Court similarly found that the Elicks didn't make a reasonable attempt to comply with the Code, noting that they acknowledged their lack of material participation and didn't assert that they acted with reasonable cause or in good faith. The late-filing addition to tax was also upheld for their 2006 return. The Elicks' claim that they were waiting for documentation from a third party, without showing that they actively sought the information or that they were unable to reasonably estimate their tax, didn't establish reasonable cause.

Appellate decision. The Ninth Circuit held that the management fees paid by the practice didn't qualify as deductible business expenses because they weren't ordinary and necessary. The record supported the Tax Court's conclusion that the management fees were not necessary to the practice's ongoing business, and the evidence corroborated the Tax Court's finding that the management fees paid by the practice didn't correspond to services actually received. (Elick v. Comm., (1/6/2016) 116 AFTR 2d 2016-457116 AFTR 2d 2016-457, see Weekly Alert ¶ 28 01/28/2016)

In addition, the Ninth Circuit found that the Tax Court properly upheld IRS's imposition of accuracy-related penalties against the Elicks and the practice based on their failure to make reasonable attempts to ascertain the accuracy of the claimed deductions. Notably, the management fees that the practice claimed fluctuated significantly from year to year and weren't corroborated by records of work performed, and the practice not only failed to establish that it received any services in exchange for those fees but also disregarded the terms of the management agreement.

Further, the Elicks' and the practice's reliance on outside advisors for tax advice and return preparation did not extend to the factual accuracy of the particular amounts claimed, where the record indicated that Dr. Elick determined those amounts. As to the late-filing penalty, the Ninth Circuit concluded that the Elicks' argument that they relied on a tax professional's advice to delay the filing did not constitute reasonable cause, noting that the Supreme Court has held that failure to timely file a tax return wasn't excused by reliance on an agent since such reliance cannot function as a substitute for compliance with an unambiguous statute. (U.S. v. Boyle, (S Ct 1985) 55 AFTR 2d 85-153555 AFTR 2d 85-1535)

Decision now final. The Supreme Court has declined to review the case. Accordingly, the Ninth Circuit's decision is now final.

References: For ordinary and necessary business expenses, see FTC 2d/FIN ¶ L-1200 ; United States Tax Reporter ¶ 1624 ; TaxDesk ¶ 255,500 ; TG ¶ 16003 .