Weekend Warriors Trailers, Inc., et al, TC Memo 2011-105
The Tax Court has determined that the fees paid from a recreational trailer manufacturing corporation to a commonly controlled S corporation under a management agreement weren't deductible business expenses. It also upheld IRS's partial disallowance of the manufacturing corporation's depreciation deductions claimed for an airplane and a boat and determined that below-market loans to the corporation's sole shareholder resulted in forgone interest income to the corporation and constructive dividends to the shareholder.
Background on business deductions. Code Sec. 162 allows a deduction for the ordinary and necessary expenses paid or incurred during the tax year in carrying on a trade or business. “Ordinary” means an expense that is a common and accepted practice in the field of business while “necessary” means an expense that is appropriate and helpful in carrying on the trade or business.
Expenses for entertainment and listed property are subject to strict substantiation requirements under Code Sec. 274(d). Listed property includes passenger autos and most other property used as a means of transportation, such as boats or airplanes. (Code Sec. 280F(d)(4)(A)(ii)) Further, under Code Sec. 274(d), no depreciation deduction is allowed under Code Sec. 167 or Code Sec. 168 for any listed property unless the strict substantiation requirements are met.
Code Sec. 168(k) allows a bonus first-year depreciation allowance for “qualified property” in the first year that the property is placed in service for use in a trade or business. Under Code Sec. 168(k)(2)(A)(ii), the “original use” of the property must begin with the taxpayer. During 2002, the bonus depreciation was 30% of the adjusted basis of the qualified property. (Under current law, a taxpayer can write off 100% of the cost of qualified property placed in service after Sept. 8, 2010 and before Jan. 1, 2012.)
Background on below-market loans. Under Code Sec. 7872, loans between parties that lack either an interest rate, or a rate that reflects market conditions, must be recharacterized to reflect the reality of the underlying transaction. As a result, the borrower is treated as having received a gift, dividend, or other type of payment depending on the situation.
Facts. Mark Warmoth is a lifelong off-road vehicle enthusiast who, after working for a major recreational vehicle (RV) manufacturer for 14 years, started his own business in '88 manufacturing a unique recreational travel trailer that he designed to transport off-road vehicles to the desert. The business was incorporated in '95 as “Weekend Warrior Trailers,” and eventually elected S corporation status in 2003. Warmoth was the sole shareholder of Weekend Warrior from its incorporation until 2009, and he was the chief executive officer (CEO) and president during the years at issue.
Weekend Warrior's restructuring. In 2002, Warmoth hired a financial planner to prepare an overall plan for him and advise him on how to handle the company's rapid growth. The financial planner, together with a team of advisors, recommended creating a corporation called “Leading Edge,” an S corporation.
On Dec. 28, 2002, Weekend Warrior and Leading Edge entered into a management agreement under which Leading Edge agreed to provide design, personnel (by transferring Weekend Warrior employees to Leading Edge and leasing them back), and management services. Weekend Warrior paid millions in management fees to Leading Edge from 2002 to 2004. Leading Edge also paid a portion of Warmoth's and top managers' wages and made several loans to Weekend Warrior. Warmoth initially received 10,000 shares of Leading Edge stock, for which he was supposed to (but didn't) pay $20,000, and he was the only member of the board of directors until early 2003.
Leading Edge was inactive after Dec. 31, 2004, and Weekend Warrior later ceased operations in July 2008.
Other transactions. In 2001, Warmoth and Weekend Warrior purchased a river boat that was to be used on the Colorado River where Warmoth owned a house and frequently entertained. No contemporaneous log was maintained regarding the business use of the boat.
In 2002, Weekend Warrior purchased an airplane. No contemporaneous mileage log was kept to record the purpose of any of the flights.
For years 2002 through 2004, Weekend Warrior made a number of loans to Warmoth.
Parties' reporting positions. From 2002 through 2004, Weekend Warrior claimed “management fee” deductions of over $4 million each year. It also claimed employee leasing fees in 2003 and 2004 of $13 and $14 million, respectively. (These were unchallenged by IRS.)
With regard to the airplane, Weekend Warrior claimed total depreciation deductions of $234,667 in 2002, $160,000 of which represented bonus depreciation, and $170,667 in depreciation for 2003 and 2004.
For 2002 through 2004, Weekend Warrior claimed $30,661, $21,897, and $21,897 in depreciation for the boat.
Leading Edge included the management and employee leasing fees in income for 2002 through 2004. It also reported small amounts of “other” income in 2003 and 2004, along with $176,495 of investment income in 2004.
Weekend Warrior reported on its Schedule Ls for 2002 through 2004 shareholder loans of approximately $1.2, $2, and $3.4 million per year. Warmoth was the only shareholder at that time.
IRS position. IRS disallowed most of Weekend Warrior's 2002 management fee deduction and recalculated it under Code Sec. 482 arms-length principles, added forgone interest to its income under Code Sec. 7872, disallowed depreciation and other deductions, made other adjustments, and imposed a Code Sec. 6662(h) 40% penalty. Similar adjustments were made for 2003 and 2004. These adjustments flowed through to Warmoth as Weekend Warrior's sole shareholder.
IRS also determined that Warmoth received a $41,343 dividend in 2002 and was subject to penalty under Code Sec. 6662(a).
Tax Court largely sides with IRS. The Tax Court concluded that the management fees 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.
The Court then determined that Weekend Warrior failed to establish business use of the airplane above the amounts allowed by IRS, and accordingly upheld IRS's partial disallowance of the depreciation deductions claimed in 2003 and 2004.
Weekend Warrior's Code Sec. 168(k) additional first-year depreciation deduction for the airplane was also denied. Even if Weekend Warrior had satisfied the Code Sec. 274(d) requirements, it wouldn't have been entitled to a Code Sec. 168(k) deduction because the airplane wasn't new when Weekend Warrior acquired it.
IRS's determination to disallow in full the depreciation deductions claimed in regard to the boat was also upheld for lack of substantiation.
The Tax Court upheld IRS's determinations regarding the below-market interest loans and their tax consequences for 2002 and 2003. However, the Court redetermined the amount of shareholder loans for 2004 based on indications in Weekend Warrior's general ledgers that there were loans and advances to other companies and individuals in addition to Warmoth.
Penalties imposed. The Tax Court, noting that IRS abandoned its prior assertion of Code Sec. 6662(h) 's 40% penalty against Weekend Warrior, found that IRS met its burden of production that Warmoth and Weekend Warrior acted negligently. IRS also satisfied its burden regarding the substantial understatement penalty for Weekend Warrior in 2002 and Warmoth in 2003 and 2004.
References: For ordinary and necessary business expenses, see FTC 2d/FIN ¶L-1200; United States Tax Reporter ¶1624; TaxDesk ¶255,500; TG ¶16003. For heightened substantiation requirements applicable to listed property, etc., see FTC 2d/FIN ¶L-4600; United States Tax Reporter ¶2744.10; TaxDesk ¶295,311; TG ¶17852. For below-market loans, see FTC 2d/FIN ¶J-6014; United States Tax Reporter ¶78,724; TaxDesk ¶319,504; TG ¶18587.