Tax News
Robucci v. Commissioner - Tax Planning No Good, the Tax Court Says
January 25, 2011
Here is a case that the Tax Court published yesterday that applies equally to investment fund related tax planning and any other tax motivated planning taxpayers may engage in. I personally have always viewed the disregarding of corporate entities by the IRS as a tough nut to crack, but in this case they did it quite successfully, and not only that, but they managed a double whammy by hitting the taxpayer with a Section 6662(a) penalty. So what happened in this case? In Robucci v. Commissioner, T.C. Memo. 2011-19, a psychiatrist sought the tax planning advice of an attorney/CPA on how to minimize his tax liability associated with his medical practice. The CPA suggested restructuring the practice from a sole proprietorship to an LLC with two members, the psychiatrist and PC (a Colorado corporation) that was going to serve as a manager.  The psychiatrist held 95% interest in the LLC (reflected on the partnership return as 10% GP interest and 85% LP interest - query, how does that make sense in an LLC?) and the remaining interest was held by PC. So, in an attempt to dodge its self-employment tax liability the psychiatrist paid self employment tax only on the 10% GP interest.

The IRS alleged that PC should be disregarded, and thus, LLC should be disregarded as well because it never elected to be treated as an association (i.e. it was a disregarded entity owned by a single owner).  The Tax Court agreed with the Commissioner. The case revolved around the two-prong test in Moline Properties. Practitioners often rely on Moline Properties that a particular entity should be respected for Federal income tax purposes, including in the private equity, venture capital, and hedge fund context. The test provides that a corporation will be recognized as a separate taxable entity if (1) the purpose for its formation is the equivalent of business activity or (2) the incorporation is followed by the carrying on of a business by the corporation.  So in other words, if the corporation is formed with a business purpose, or it engages in business activity, it should be respected. This is a pretty low threshold to meet. However, the doctor in this case failed to prove either of these two prongs.  The Tax Court noted that PC was appointed as a manager but there was no evidence that it performed any management, had no assets, had no service contracts with LLC and paid no salary to anybody. Not only that but the record showed that the CPA advising the doctor had written a note stating that the entity actually does nothing.  The court went on to conclude that PC was a hollow corporate shell. 

This case seems to be a fine example of how things can go wrong pretty fast and out of the blue. Did the CPA ever think that his note will be produced in court? - probably not.  Service and management contracts - who needs them? Resolutions or other evidence of some actual management activities? - none.  Well, it seems that this case might have turned out differently had everything been documented and done with more foresight.  In the investment fund context, one can envision similar attack against blocker entities, shell GP entities or any tax motivated transactions that involve setting up an entity without an apparent business purpose.  This case is a fine reminder that documenting the bona fides of the entity, the purpose of the entity, and later recording the actual activities in support of that purpose could mean the difference between win or lose in court.
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