Dental practice's management fees were not ordinary and necessary business expenses.

• Author: Chang, Anne

In May 2016, the Supreme Court declined to review a decision of the Ninth Circuit that denied deductions for management fees claimed by a dental practice as ordinary and necessary business expenses within the meaning of Sec. 162 (Elick, 638 Fed. Appx. 609 (9th Cir. 2016), aff'g T.C. Memo. 2013-139). The Ninth Circuit had affirmed the Tax Court's decision that the management fees were unnecessary because the taxpayer did not provide proof to show that any services were actually performed in exchange for the fees, and thus the taxpayer could not deduct them.

Facts

At the times relevant to the case, Wiley M. Elick DDS Inc. was a dental practice. Dr. Wiley Elick and his wife, Sharon Elick, were the practice's sole shareholders and board members, and they were both salaried employees. The practice also employed a bookkeeper/office manager, who was also paid a salary.

In 2002, Dr. Elick consulted with what the Tax Court called a "professional" who advised him to set up a company to manage the practice's operations. Thus, Dr. Elick started a company, SD Management Group Inc. (SDG), for this purpose, which established an employee stock ownership plan (ESOP) to benefit the practice's employees. The ESOP purchased all of the SDG stock from Dr. Elick, who was SDG's sole owner, officer, and board member.

SDG and the practice then entered into an agreement to manage the practice's operations (management agreement). SDG agreed to produce annual capital, operating, and cash flow budget plans; investigate and document 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. SDG did not have any 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 hill time and performed many of the functions that SDG was to provide. The practice paid SDG management fees of $430,000 for 2005 and $303,000 for 2006. These amounts were determined by Dr. Elick.

On its Forms 1120, U.S. Corporation Income Tax Return, for 2005 and 2006, the practice claimed business expense deductions for the management fees. The IRS issued deficiency...