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Tax Court: the play call wasn't bad, but they muffed the handoff

January 25, 2011

A Denver psychiatrist got together with a tax advisor to put together the tax structure for his practice. What they came up with was an LLC owned 95% by the psychiatrist and 5% by a professional corporation owned by the psychiatrist. The 95% was further split between a 10% "general partner" interest an 85% "limited" interest. A second corporation was formed to receive a "management fee" for services to the entity and to provide deductible and excludable health insurance benefits to the doctor.

One important goal was to limit self-employment taxes -- the 15.3% tax imposed on the self employed in place of employer and employee social security taxes -- to earnings on the 10% "general partner" interest.

The psychiatrist, Dr. Robucci, used a Mr. Carson to put together the structure. And it just might have worked. But it didn't, and the psychiatrist will have to cough up significant taxes and penalties because, according to the Tax Court opinion, the follow-through was lacking:

It is not that Mr. Carson'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.

What went wrong?

Although Robucci P.C. and Westsphere were properly formed under Colorado law to carry out legitimate corporate functions, the fact that they were nothing more than empty shells, devoid of property, personnel, or actual day-to-day activities, i.e., of substance, 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.

The taxpayer failed to convince the Tax Court that the corporation actually did anything. As a result, the court disregarded the existence of the corporation for tax purposes and treated the LLC as owned 100% directly by the doctor -- leaving him liable for self-employment taxes on all of the practice income and costing him the tax-free status of his fringe benefits:

The result is that Dr. Robucci is treated as a sole proprietor for Federal tax purposes, which was his status before the formation of Robucci LLC and the corporations. It follows, and we hold, that the net income arising from his psychiatric practice during the years in issue, including any amounts paid to Robucci P.C. and Westsphere [the management corporation], was self-employment income of Dr. Robucci subject to self-employment tax under section 1401.

The court also held that the circumstances of the structure, including the lack of substantial activity in the P.C., should have tipped off the doctor that something was wrong. As a result, the doctor wasn't entitled to rely on the tax advisor and was liable for penalties.

The Moral? A good tax idea isn't worth much unless you follow through.

Cite: Robucci, T.C. Memo 2011-19

UPDATE, 1/31/2011: Marc Ward has more.

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