Management Fees Deduction Denied by Tax Court

In a recent decision, the Tax Court has determined that management fees paid from a recreational trailer manufacturing corporation to a commonly controlled S-Corporation under a management agreement weren't deductible business expenses.

Taxpayer was a lifelong off-road vehicle enthusiast who, after working for a major recreational vehicle (RV) manufacturer for 14 years, started his own business manufacturing a unique recreational travel trailer that he designed to transport off-road vehicles to the desert. The business was incorporated in 1995 as “Weekend Warrior Trailers,” and eventually elected S-Corporation status in 2003. In 2002, the taxpayer incorporated a related company called “Leading Edge”. Weekend Warrior and Leading Edge entered into a management agreement under which Leading Edge agreed to provide management services. From 2002 through 2004, Weekend Warrior claimed “management fee” deductions of over $4 million each year. Leading Edge included the management fees in income for 2002 through 2004.

The Tax Court concluded that the management fees paid in 2002 weren't deductible under Code Sec. 162. The record contained scant evidence showing what services were performed or any other details of the parties' relationship, leaving the Court unable to determine whether the fees were reasonable and necessary. Under power granted by Code Section 482, the IRS recalculated the 2002 management fee deduction using arms-length principles. 

The IRS attacked management fees paid in 2002 because during that year Weekend Warrior was a C-Corporation and Leading Edge was an S-Corporation. The IRS did not make any adjustments in years 2003 and 2004 when both companies were S-Corporations with the same ownership.

Taxpayers who have management agreements in place with related entities need to make sure substance follows form. Maintaining documentation relating to management services provided will help fend off an attack by the IRS. This is especially important when one of the related entities is a pass-through entity such as an S-Corporation, Partnership or LLC and the other entity is a C-Corporation.