TAX COURT STRIKES DOWN USE MADE OF MANAGEMENT STRUCTURE USED TO SAVE EMPLOYMENT TAXES--TREATS PC MEMBER AS PEPPERCORN!!02 / 01 / 2011
The United States Tax Court has refused to go along with a CPA's recommended restructuring of a psychiatrist's sole proprietorship practice, into a multi-member LLC consisting of himself, holding a 95% interest, and 5% owned by a PC (holding its interest akin to that of a limited partner). Instead, the Tax Court "reclassified" the structure as nothing more than paper shuffling, whereby the practice was nothing more than what it was before the plan: a disregarded entity under the so-called check-the-box principles, whereby the "true earner" of the income of the practice was the psychiatrist.
Of concern to the Tax Court was the fact that no written explanation was given to the psychiatrist as to why Dr. Robucci needed to form 3 separate entities, inclusive of Westphere, a corporation that was to assist with practice management. Dr. Robucci was the sole shareholder of the two corporations, Robucci PC and Westphere. As to the 95% interest, two additional K-1s were issued, one to Dr. Robucci as the general partner, at 10%, and another, to him, as the limited partner, at 85%. The CPA determined these ownership percentages, claiming to have an expertise in valuation, and based on his assessment of the value of Dr. Robucci's goodwill and what would be a reasonable rate of return on that goodwill at the time he formed Robucci, LLC, with the 85% interest attributable to a capital contribution of intangibles. No formal written assignment was made of the tangible or intangible assets of his practice to the LLC, nor was there a written opinion of valuation provided by the CPA. As President of Westphere, a loan agreement was utilized to authorize him, as an employee, to borrow money, from time to time under certain specified terms and conditions. Court, at 8. An employee business expense reimbursement plan was implemented by Dr. Robucci for Westphere. Two additional plans went into place, a Medical Reimbursement Plan for the Westphere management entity, and a Diagnostic Medical Reimbursement Plan. The CPA drafted the Operating Agreement for Robucci, LLC, and under that document, Robucci, PC was designated to be the manager, but it is not clear if the same was executed. The entire "plan" was understood by Dr. Robucci to be a legitimate means of achieving tax minimization. Court, at 9.
Robucci, LLC and Westphere had separate bank accounts, but Robucci PC did not. Dr. Robucci did not have an employment agreement with any of the three separate entities, nor did any of them have other employees during the years at issue. No salary was paid by Robucci PC or Westphere to Dr. Robucci, or to anyone else. No time records kept as to the time he claims to have spent working for Westphere. Yet, Robucci LLC deducted "management fees" for each of the years in amounts of $31,475, $25,500, and $38,385, but these amounts did not appear to match up with the bank statements. Court, at 9-10.
The billing assistant for the practice remained the same, and she received a percentage of what she collected from patients. During the years at issue, the physician continued to bill Medicare and Medicaid as an individual practitioner under his own SSN. Court at 10.
The corporations did not have separate websites or telephone listings, did not pay rent to the doctor or the LLC, did not have separate customers or third party vendors, and did not advertise. Westphere did not have separate, dedicated space in Dr. Robucci's office. Court, at 11.
The Court notes that "Dr. Robucci is not the first, and, most certainly, he will not be the last individual to attempt to donduct his business affairs, in this case a medical practice, in a manner that he hopes will minimize his Federal income tax liability arising therefrom. That he may do so has become axiomatic." Court, at 12 (citing to Gregory v. Helvering, 293 U.S. 465, 469 (1935)). However the court, notes that even under that standard, "....but the question for determination is whether what was done, apart from tax motive, was the thing the statute intended." Id.
As the Court put it, ought the corporations be disregarded, and Dr. Robucci treated as the "true earner" of the income from his practice, such that the check-the-box rules might further treat the LLC as a single-member LLC, properly disregarded under the check-the-box regulations, absent any affirmative corporate election? Court, at 14. The court noted that the IRS did not attempt to disregard the LLC on the basis that it is a sham. Id.
Dr. Robucci argued that Robucci, PC, as the "managing member" of Robucci, LLC, performed oversight and management services, and that Westphere was established to provide oversight, and to manage certain overheads and indirect expenses, including employee benefits such as health insurance, track business expenses, and create a "group" for sickness and health coverages. He also argued that the formation of a multi-member LLC, with a corporate managing member, afforded him superior liability protection under Colorado law, and that the PC's interest in the LLC was necessary to accomplish this goal. The IRS countered that the corporations were created solely for the purpose of reducing Dr. Robucci's tax liability, and in particular, help him avoid both income and self-employment taxes, and they did not offer any credible explanation of the business purpose for forming the corporations, or that either corporation engaged in any business activity after it was formed. Court, at 16.
In agreeing with the IRS, the Tax Court held that the corporations had to be incorporated for a purpose that is the equivalent of a business activity, but that this was not supported. The Court found that no evidence was presented which showed how the PC actually performed any management or other services for the LLC, noting also that it had no assets (other than its interest in the LLC) and no employees. Court, at 17.
Notably, a handwritten note from the CPA was put into evidence. It stated that "We need PC to be a partner in LLC only Westphere is the mgmt. corp. PC does nada (nothing)." Court at 18. Rejecting the taxpayer's reliance on Albright, and instead, viewing, the PC as nothing more than a peppercorn member of the LLC, the PC was not formed for a purpose that is the equivalent of a business activity under the first prong of the Moline Properties test. Id., at 20.
Similarly, as to Westphere, the Court rejected the suggested business purposes for its creation, finding that the evidence refutes the notion that the alleged purposes constituted bona fide nontax purposes for the organization of that entity. While Westphere did have a checking account, like the PC, it had no employment agreement with Dr. Robucci, and no employees. It did not show how it performed management or other services for the LLC. Instead, as the Court noted, Dr. Robucci continued to conduct his practice as he always had, including retention of his billing assistant. The fact that the expenses of his practice are being paid out of the LLC's bank account was not legally significant. The court found no proper correlation between debits to the Westphere bank account and credits to the LLC's bank account, and essentially, this shows how the interaccount transfers were the equivalent of taking money from one pocket and putting it into another. Such interaccount transfers, without proper accountings, does not qualify as a "business activity" within the contemplation of Moline Properties.
Essentially, the Court found that both the PC and Westphere were "hollow corporate shells" and this led the Court to further conclude that neither carried on a business after incorporation, under the second prong of Moline Properties. Court, at 23. The Court found that the LLC's effort to deduct over $95,000 of management fees resulted in a substantial tax benefit to Dr. Robucci by further reducing the LLC's potential distribution to him of income at least a portion of which otherwise would have been subject to self-employment tax. Because the PC and Westphere served no significant purpose or function other than tax avoidance, the Court agreed with the IRS that they should be disregarded, relying on Aldon Homes, Inc. v. IRS, 33 T.C. at 598 (disregarding 16 so-called alphabet corporations).
In deciding to further assess a negligence penalty, the IRS noted that whereby a taxpayer may usually rely on the advice of a professional tax adviser, lawyer or accountant, reliance is not reasonable if the adviser is a promoter of the transaction or suffers from a "conflict of interest that the taxpayer knew of or should have known about." Court, at 26. The IRS claimed that there was no reasonable cause for the positions taken by Dr. Robucci and that he did not act in good faith. As the IRS saw it, he should have sought a second opinion after getting advice that was clearly too good to be true. Court, at 27.
The IRS also viewed the CPA as a promoter of an arrangement, who earned substantial fees for incorporating sham entities and preparing tax returns. The Court indicated that even if it were to agree that the CPA was not a promoter, it would agree with the IRS that the tax result afformed by the CPA's suggestions were "too good to be true." Court, at 28.
"It is not that (CPA's) goal of directing some of Dr. Robucci's income to a third-party corporate management service provider and bifurcating Dr. Robucci's interest in Robucci LLC so that he would be separately compensated for the use of his intangibles was obviously unreasonable. On the contrary, had it been more carefully implemented, it well might have been realized, at least in part. The problem for Dr. Robucci is that (CPA's) strategy for implementing his tax minimization goal was patently inadequate to the task, a fact that should have been obvious to Dr. Robucci and have prompted him to either question (CPA) or seek second opinion." As for the proper formation of corporations under Colorado law, the Court noted that these were "empty shells, devoid of property, personnel, or actual day-to-day activites, i.e., of substance, and accordingly, this should have sent warning signals to Dr. Robucci that those corporations were not effecting any meaningful change in the prior conduct of his medical practice." Court, at 29.
As the Court puts it, "there is no support for any charge from Westphere to Robucci LLC for such services or for the claim that Dr. Robucci was wearing a Westphere hat when he performed them. For Dr. Robucci, aside from signing a raft of documents and shifting some money between two bank accounts, it was business as usual. The lack of any formal transfer of the intangibles to the LLC should have been cause for concern. By not questioning the efficacy of the arrangement that purported to minimize his taxes while effecting virtually no change in the conduct of his medical practice, he failed to exercise the ordinary business care and prudence required of him under the circumstances. Therefore, the Court applied the accuracy-related penalties. Court at 30.