IRC section 162(a) states the basic rule for deducting business expenses from gross income. The section states that in order to deduct business expenses from a taxpayer's gross income, those expenses must be "ordinary and necessary." As this opinion implicitly points out, the definitions of the terms ordinary and necessary are the result of case law and not something defined in the code.
An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a transaction 'of common or frequent occurrence in the type of business involved.' Deputy v. du Pont, 308 U.S. 488, 495 (1940).
An expense is necessary if it is appropriate and helpful for the development of the business. Commissioner v. Heininger, 320 U.S. 467, 475 (1943).
On top of these definitions, the tax court overlays an additional requirement: reasonableness.
The Court of Appeals for the Sixth Circuit, to which any appeal of this case would lie, has held that for expenses to be deductible as ordinary and necessary, they must be reasonable, because 'the element of reasonableness is inherent in the phrase 'ordinary and necessary.' Commissioner v. Lincoln Elec. Co., 176 F.2d 815, 817 (6th Cir. 1949).
The facts in this case are fairly straightforward. The taxpayers owned, among others, a corporation called Top Line Express, Inc. and a limited liability company called Grasshopper Leasing, L.L.C. Top Line Express is trucking company. Grasshopper is truck leasing company. Grasshoper often would lease trucks to Top Line Trucking.
During the tax years 2004 and 2005, Grasshopper paid Top Line approximately $210,000 for management and administrative services. Because Grasshopper is a passthrough entity, its income and expenses passthrough to its members and are reported on the member's individual income tax return. In this case, the taxpayers reported the $210,000 management and administrative services as deductions on their individual income tax return.
The IRS disallowed these deductions, arguing the expenses did not meet the section 162(a) rule, i.e. they were not ordinary and necessary business expenses of Grasshopper.
After stating the general rule of law discussed above, the tax court held for the IRS. In its analysis, the court found dispositive the following facts:
[P]etitioners have failed to demonstrate how the management fees in question were determined. They have no contemporaneous documentation. . . . There was no written contract for the management fees. We question whether these amounts were determined at arm's length, since petitions was the sole owner of both Grasshopper Leasing and Top Line Express. (7).
According to petitioner's testimony . . . over half the hours allegedly worked by Top Line employees on behalf of Grasshopper consisted of services in the categories of sales management, safety, and driver relations. Petitioners have not convinced us that it was necessary for Grasshopper to incur expenses for such services . . . since Grasshopper had no customers other than Top Line and other related entities. Moreover, . . . Grasshopper had [no] need to recruit, train, test, track, or dispatch truck drivers, since it employed no drivers. In addition, we are not convinced that [the] consulting services that petitioner allegedly provided to Grasshopper were performed in his capacity as an employee of Top Line rather than in his individual capacity as sole owner of Grasshopper. Indeed, because Grasshopper had no other owners and no employees, it is not apparent with whom at Grasshopper petitioner might have consulted, other than himself. (10).
Hopefully it becomes clear to the reader the scam that the taxpayer in this case was trying to pull off. It should become equally clear how the tax court saw right through it.
The taxpayer thought he could create business deductions in a passthrough entity by having his LLC pay "management expenses" to his corporation. This creates taxable income for the corporation and expense for the LLC. The LLC is a passthrough entity, thus the expense flows through to his individual income tax return, where he can use those expenses to offset other income such as wages and interest income. The revenue is of course taxable income inside his corporation, but probably taxed at lower corporate rates, and most likely offset by significant expenses in his trucking business.
Notwithstanding the fact that the IRS caught the taxpayer, it makes no sense to me why the taxpayer tried to shift income from a passthrough entity into a corporate entity. Shareholders of the corporate entity pay two levels of tax: the corporate level tax, and the dividend tax. Now that the taxpayer has created taxable income in his corporate entity, he will pay dividend tax when he, as the sole shareholder, receives the income.
It would be interesting to know if the IRS will let the taxpayer unwind this transaction. The worst case scenario for the taxpayer would be for the IRS to not only disallow the deduction (which is what occurred here) but also require Top Line to pay tax on the income...after all, there is no requirement that revenue be "ordinary and necessary" before it is subject to tax!
Finally, the best part of the opinion is when the tax court took note that Grasshopper had no employees, let alone truck drivers, so why did Grasshopper need to pay for driver safety. If you are going to set up a scam, at least make sure it passes the "hold your nose" test.