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In our last article, we talked about how – in very specific circumstances – having both an S-Corp and a C-Corp can save you significant amounts of money on your taxes.

But how do you implement it?

The answer a lot of advisors will give is to simply set up a licensing agreement between your S-Corp and the C-Corp. You assign all of your intellectual property to the C-Corp and then have the S-Corp pay a licensing fee for it. This is an expense for the S-Corp and moves the money into the C-Corp where (at least in this instance) it is going to be taxed more favorably.

And that can be legitimate. There is nothing inherently wrong with those types of licensing arrangements.

The problem is that – at least in our experience – these structures are not set up appropriately and would not withstand scrutiny if audited.

Substance Over Form Required

So why do they fail?

The first issue is that there needs to be economic substance to the transaction. It cannot be done purely for the purpose of tax avoidance. So it does not matter if you have licensing agreements signed and the money is being paid from one entity to the other. If the only reason for the arrangement is to avoid taxes without an underlying and legitimate business purpose for the arrangement, then the arrangement will fail.

Gregory v. Helvering, 293 U.S. 465 (1935) was a key case that established this. In that case, Gregory created a shell company for the purpose of avoiding capital gains on the sale of her business stock. The IRS challenged and the court held that – while the transactions may have followed the letter of the law – it was a sham transaction done just to avoid taxes. The case solidified a few key areas:

1. The idea of “substance over form”. That even if a transaction technically complied with the tax code, that is not in and itself enough. Tax courts have to look at the substance/purpose of a transaction and not just if it technically follows the law
2. The “legitimate purpose test” where a transaction needs to have a business purpose and not just be a tool for tax avoidance

Precedent For Expenses Being Disallowed

One of the cases that best outlines this is Aspro, Inc. v. Commissioner, TC Memo 2021-8. In it, the IRS disallowed “management fees” that were paid from a C-Corporation to the shareholders. The original tax court and appellate court noted the following:

1. Aspro “paid management fees in amounts roughly proportional to the ownership interests of the stockholders.”
2. The company had “not carried its burden of showing that the management fees paid […] were reasonable.”
3. Even if Aspro had shown the compensation was reasonable, the court cited David Watson v. United States noting that “in the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness.”
   1. In essence, regardless of the reasonableness of the rate paid, disguised distributions cannot be deducted. And court agreed that they were “not paid as compensation for services but were instead disguised distributions of corporate earnings.”
4. “Compensation paid by the corporation to shareholders is closely scrutinized to make sure the payments are not disguised distributions.”
5. “Aspro produced no written management-services agreement or other documentation of a service relationship between Aspro and either entity, no evidence of how Aspro determined the amount of the management fees, and no evidence that either entity billed Aspro or sent invoices for any services performed for Aspro.”
6. Aspro’s “process of setting management fees was unstructured and had little if any relation to the services performed.”
7. Aspro’s “operating margins before paying management fees were strong compared to those of its industry peers (4.4% in tax year 2012, 7.6% in tax year 2013, and 8.1% in tax year 2014) but were relatively very weak once management fees were paid (negative 0.1%, negative 0.2%, and 0.4%) […] By paying such high shareholder compensation, petitioner was less profitable as illustrated by its lower operating income margins compared to those of its industry peers.”
8. “Some courts have supplemented or completely replaced the multifactor approach for analyzing shareholder-employee compensation with the independent investor test. […] The independent investor test asks whether an inactive, independent investor would have been willing to pay the amount of disputed shareholder-employee compensation considering the particular facts of each case.”
9. The company’s “rationale for the management fees appears to be a last-minute scramble to list everything anyone remotely associated with either corporate shareholder did for petitioner.”

Do you see how that same scrutiny could very easily be applied to an owner who owns one company paying licensing fees to another company they also own?

And some of those deficits could be cured (making consistent payments throughout the year, documenting the licensing arrangement and having signed agreements, making it very clear what services were being rendered for the payment received, etc.), but some cannot – like the common ownership between the entities.

One of the most important factors listed is the independent investor test. Would any independent investor approve of an arrangement where a company loses all of its IP to another and then pays exorbitant fees to continue using that same IP? If this was an arm’s length transaction, would it actually go through?

Again, there’s nothing inherently wrong with these arrangements. But they need to be done carefully and there are limits to how much money can be paid. The amounts paid need to be reasonable. What we have seen suggested all too often are preposterously high amounts being paid (and sometimes to different jurisdictions to avoid state income taxes, which is another topic altogether). Arrangements like that will fail if they were ever audited.

Deduction Disallowed? Pay Income Tax Twice

One of the factors that I’ve never seen any advisor who pitches this structure acknowledge is the tremendous risk if you are audited and the deduction is disallowed.

Most will say something along the lines of “okay, so you pay the tax you would have paid anyways plus a penalty, right? What’s the big deal?”

And that would be true for most business deductions, but not for this. Why? Because these deductions are income you are claiming somewhere else.

Here’s how it works. You only have three years after your return was originally filed to do an amendment. But the IRS has up to six years to audit you if they believe you substantially underreported your income. And court cases take years to litigate, especially if one side appeals.

Put simply: if the deduction on the S-Corp side (where you are expensing the IP fees) gets disallowed, by the time that is decided it is very likely going to be well past the statute of limitations where you could amend your C-Corp return and not claim the IP fees as revenue.

So you’d end up paying tax on that income twice.

That’s what happened in Brinks Gilson & Lione, A Professional Corp. v. Commissioner, T.C. Memo. 2016-20. In that case, the IRS disallowed the deduction for compensation paid to shareholder employees in a C-Corp. The employees would have claimed that as income on their W-2s/individual returns.

In Brinks, the case covered the 2007 and 2008 tax years but it was not decided by the courts until 2016. At which point it would have been well past the statute of limitations for those shareholder employees to amend their individual returns. So they paid tax on the income twice: once on the individual return when they originally filed and again when the C-Corp return was adjusted via the tax court nearly a decade later.

The Better Approach: Truly Separate Companies

So what should you do instead? Create two companies that are truly and legitimately separate enterprises. That both have their own revenue streams and expenses. If you don’t have a second company you are already starting, this may involve working with a CPA and attorney to split your existing business into two separate entities – which just happen to be taxed as a C-Corp and an S-Corp. And even that has to be done carefully and with legitimate business purpose.

It’s not the easy approach, which is why the gurus don’t talk about it. It is obviously much easier to just set up a shell company and move money into it a few times a year to reduce your S-Corp’s income. And that ease makes for a much better elevator pitch.

But that approach is going to get you walloped if you were ever to get audited – to the tune of potentially paying DOUBLE what you would have paid originally.

So if this approach makes sense for you, explore creating a spin off company or splitting your existing company into two. They just need to operate as true, legitimate businesses. And if it makes sense to have some IP licensing as a modest component of that (and your attorney signs off on it), have at it. Remember: there’s nothing wrong with tax saving strategies so long as there is legitimate economic substance behind them. The IRS could very well see that you structured your businesses this way to reduce your tax burden. But so long as that is not the only reason it was done, that’s fine.

Conclusion

Structuring things this way is much, much more likely to withstand audit scrutiny vs. some sham transactions thinly disguised as licensing fees.

Be smart and don’t go with the “easy” route if this structure makes sense for you. It is absolutely not worth the risk. The amount you will pay – monetarily, with your time, and with your energy – will be much more than the time and money saved by trying to take a shortcut.

FAQ

Any accounting, business, or tax advice contained in this communication, including attachments and enclosures, is not intended as a thorough, in-depth analysis of specific issues, nor a substitute for a formal opinion, nor is it sufficient to avoid tax-related penalties.