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Mixing Holidays With Business

Hope you had a good Thanksgiving Holiday. Some of us probably feel we ate or drank either too much or not enough, watched too much or not enough football, or spent too much time discussing politics and the state of the Dis-Union with family or friends. Then there were some who, having overheard in the midst of the merrymaking how someone else had implemented what sounded like a wonderful tax-saving strategy, resolved to do the same themselves for 2024.[i]

The tax-saving strategy considered in a recent decision of the U.S. Tax Court,[ii] which involved the employment of family members, sounds like it could have been a plan that was hatched over a turkey drumstick and stuffing,[iii] or after one too many slices of pie.[iv] The only surprise, at least for me, was the outcome.

Sole Proprietorship

Taxpayer worked for Company as a salaried executive employee who was responsible for increasing sales and developing new marketing.

In addition to working for Company, Taxpayer owned and operated a sole proprietorship during the years preceding the tax years in question. Doing business as “Marketing,” Taxpayer identified new markets for chemical producers and connected them with potential customers.

Marketing earned commissions on sales to the customers Taxpayer identified. Taxpayer reported Marketing’s income and expenses on Schedule C, Profit or Loss From Business.[v]

Marketing maintained a qualified retirement plan. Taxpayer mailed checks to the retirement plan to cover contributions to the accounts maintained for Taxpayer, Spouse, and their Sons (Son-1 and Son-2).

According to Taxpayer, Marketing was a family business that Taxpayer wished to pass on to Sons.

In fact, Taxpayer claimed to have started training Sons when they were in high school and, while they were in college, he assigned them research tasks and oversaw their work.  

Income Tax Plan

By the start of the audit period,[vi] Marketing was generating substantial income. Around that time Taxpayer engaged Consultant to evaluate Marketing’s organizational structure, facilitate succession planning, and reduce Taxpayer’s income tax exposure.

After interviewing Taxpayer and reviewing their financial information, Consultant estimated that Taxpayer’s “average tax rate” (ratio of tax to taxable income) was 37-percent. Consultant advised that if Taxpayer adopted Consultant’s recommendations (the Plan), they could reduce their “average tax rate” to 9-percent. According to Consultant, Taxpayer could achieve that goal by restructuring their business to facilitate greater tax deductions. Consultant explained:

“[M]arginal rates are important for measuring income tax saving from deductions. The marginal rate is the rate applied to the last Dollar [sic] earned. If a deduction can be created, that deduction will create income tax savings at the marginal rate. So if your marginal rate is 48.40%, for each $100 of deduction created, tax savings of $48 will occur.”

Based upon this above strategy, Consultant advised Taxpayer to (1) convert Marketing to an S corporation and (2) rent certain residential properties owned by Taxpayer (and previously used rent-free by Sons while they were in college)[vii] to the S corporation “for business purposes at a reasonable per day rate supported by independent comparables.”


Under the Plan, the S corporation would rent each of Taxpayer’s residential properties for a maximum of 14 days and deduct that expense on its income tax return. Taxpayer, in turn, would exclude their corresponding rental income.[viii]   

Consultant included a tax saving projection in the Plan. For purposes of that projection, Consultant “assumed” certain per-day rental rates for each property. Despite those assumptions, Consultant warned Taxpayer that the rental rates “should be supported by independent comps [sic] within a 100 mile radius.” Consultant also suggested that Taxpayer retain a professional appraiser to value the rental rate every few years.[ix]

Marketing Services

Another component of the Plan was the creation of a C corporation, which would provide “marketing” services to the S Corporation.

Under the Plan, the S corporation would pay the C corporation a yearly marketing fee, which, according to Consultant, “should not exceed more than 10%” of the S corporation’s gross income.

The C corporation, in turn, would pay and deduct on its income tax returns the following expenses: (1) deferred compensation plan payments, (2) tuition for Taxpayer’s sons, (3) medical expenses and disability plans for Taxpayer’s family, (4) overtime and weekend meals for the employees, (5) meals for Taxpayer’s family “for the convenience of the employer,” and (6) salaries to Taxpayer’s children.[x]

As for the nature of the marketing services, the Plan stated: “The C Corporation should pay for marketing expenses for the benefit of the Operating Entity [the S corporation]. These expenses may be for items such as promotional materials and little league sponsorships showing that this company is very active.”[xi]

Implementing the Plan

Taxpayer organized S Corp. to conduct the business previously done as Marketing. Spouse was the sole owner of S Corp, which elected to be treated as an S corporation for income tax purposes.[xii]

During most of the audit period, Sons purported to be employees of S Corp.

Before engaging Consultant, Taxpayer used hotels and restaurants to conduct business meetings for Marketing. At the start of the audit period, Taxpayer moved those meetings to the above-referenced residential properties.

After Marketing’s incorporation, Taxpayer began charging rent to S Corp for the use of those properties. Pursuant to the Plan, S Corp rented each of these residential properties for a maximum of 14 days. Taxpayer invoiced S Corp using the rates Consultant had assumed for purposes of making a tax saving projection in the Plan; Taxpayer did not obtain any appraisals of their properties for purposes of valuing the daily rental rates.

Taxpayer also incorporated C Corp. as a new “marketing” company, in accordance with the Plan. Organized as a C corporation, C Corp issued 4 shares of stock to Taxpayer, 48 shares to an unrelated individual, and 48 shares to another unrelated individual.[xiii] 

Taxpayer, Spouse and Sons (together, the Family) were appointed directors and engaged as part-time employees of C Corp.

At the initial meeting of shareholders and directors, the Family in their capacity as directors adopted several “plans” for the benefit of C Corp’s employees, including plans for (1) medical expense reimbursement, (2) overtime and weekend meal reimbursement, (3) meals furnished for the convenience of the employer, (4) mileage, (5) dwelling unit leasing, (6) tuition, and (7) fitness and country club expenses.

With respect to C Corp’s marketing activities, the minutes from the initial board meeting stated:

“A new Marketing Company has been formed and marketing activities are allocated by written agreement to the new Marketing Company. The Marketing Company conducts marketing events at the house of the Employee. Also employee meetings are now being held at the house of the Employee.

“As the marketing activities are being conducted by a separate legal entity, the Operating Company is not liable for those activities. This allows more marketing events to be conducted as the Operating Company will be free from liqueur liability and slip and fall liability.

“While all marketing decisions were made at the Operating Company level, now those decisions are being made at the Marketing Company level.”[xiv]


During the years in issue, S Corp made annual payments to C Corp for purported marketing services. The marketing fees were C Corp’s only source of income.

C Corp used the marketing fees to pay several personal expenses of the Family. It did not use any portion of the funds to pay C Corp’s marketing expenses. Nor did it host marketing or promotional events on S Corp’s behalf, as the minutes of the initial board meeting had envisioned.

The CPA who prepared Taxpayer’s Forms 1040, U.S. Individual Income Tax Return, for the first year in issue prepared a Schedule C for Marketing. On that Schedule C, Taxpayer claimed a deduction for Marketing’s contribution to Sons’ retirement accounts. Taxpayer also claimed a deduction for travel expenses.

S Corp filed Forms 1120S, U.S. Income Tax Return for an S Corporation, for the remaining years in issue. For each such year, S Corp deducted the rent Taxpayer had invoiced for the “use” of the residential properties.

S Corp also claimed various “other” deductions.[xv]

After deducting its reported expenses, S Corp reported ordinary business income, which Taxpayer reported on Schedule E, Supplemental Income and Loss, for the years in issue.[xvi]

Taxpayer also reported rental income from S Corp on Schedule E but excluded those amounts from their gross income.[xvii]

C Corp reported the marketing fees it had received from S Corp on Form 1120, U.S. Corporation Income Tax Return. Besides the marketing fees from S Corp, C Corp did not report any income.

It did not claim any deductions for officer compensation or wages but deducted several personal expenses of the Family, including (1) out-of-pocket medical bills, (2) meals and entertainment, (3) Taxpayer’s mileage, (4) portions of Sons’ tuitions, (5) Taxpayer’s health club membership, and (6) lawn care.[xviii] Seriously.


During the examination of Taxpayer’s, S Corp’s, and C Corp’s tax returns,[xix] the IRS fully disallowed S Corp’s rent deductions for the years in issue and most of C Corp’s “other” deductions.

The IRS issued Taxpayer notices of deficiency (NODs) determining federal income tax deficiencies for each of the years in issue. 

The NODs increased Taxpayer’s passthrough income for these years after making the above-described adjustments to S Corp’s rental and “other” deductions.[xx]

The IRS also adjusted Taxpayer’s Schedule C[xxi] for the first of the audit years by disallowing the Schedule C deductions for travel and pension and profit sharing expenses.

However, the IRS did not determine any deficiencies with respect to C Corp, finding instead that the corporation’s Forms 1120 for the years in question were “sham” returns.[xxii]

In response to the NODs, Taxpayer timely petitioned the U.S. Tax Court.

The discussion below focuses on the deductions claimed for the retirement plan contributions and for the rent paid.[xxiii] 

Tax Court

The Code allows deductions for ordinary and necessary expenses paid or incurred by a taxpayer during the taxable year in carrying on a trade or business.[xxiv]

According to the Court, the taxpayer generally bears the burden of proving they are entitled to the deductions claimed. 

The Court explained that a taxpayer is required to maintain records that are sufficient to enable the IRS to determine the correct tax liability.[xxv] 

Thus, the taxpayer must demonstrate that a particular deduction claimed is allowable pursuant to a statutory provision and must further substantiate that the expense to which the deduction relates was paid or incurred.

If the taxpayer can establish that they paid or incurred a deductible expense but cannot substantiate the precise amount, the Court may try to approximate the deductible amount of the expense. However, the taxpayer must present sufficient evidence to establish a rational basis for making the estimate.[xxvi] 

Having set out the foregoing analytical framework, the Court turned to the deductions in question.

Retirement Plan Expense

On Schedule C of Form 1040 for the years preceding the incorporation of S Corp, Taxpayer deducted as a pension and profit-sharing expense Taxpayer’s contribution to Sons’ respective qualified retirement accounts.

The IRS disputed the deduction, contending that neither Son was an employee of Taxpayer.

The Code allows an employer to deduct certain contributions to deferred compensation plans that are paid or accrued on account of an employee.[xxvii] 


The Court explained that whether an employer-employee relationship exists is a question of fact.  Typically, courts apply a common law agency test to determine whether an employer-employee relationship exists. 

Moreover, the Court emphasized that where a family relationship is involved, close scrutiny is required to determine whether a bona fide employer-employee relationship existed and whether payments were made on account of the employer-employee relationship or on account of the family relationship.[xxviii] 

In determining whether a person is an employee under the general common law of agency, several nonexclusive factors are considered. Inevitably, cases turn on their particular facts, and no one factor is controlling. Among these factors are the following: (1) the degree of control exercised by the principal over the details of the work; (2) which party invests in the facilities used in the work; (3) the opportunity of the individual for profit or loss; (4) whether the principal has the right to discharge the individual; (5) whether the work is part of the principal’s regular business; (6) the permanency of the relationship; and (7) the relationship the parties believe they are creating. 

Taxpayer’s Testimony

According to the Court, at trial Taxpayer credibly testified that they viewed Marketing – the sole proprietorship which later became S Corp – as a family business. Taxpayer also credibly testified, the Court continued, that they wished to pass this business on to Sons.

The record established that Taxpayer pursued that goal. Although Sons were in college during part of the audit period, Taxpayer credibly recounted assigning them research tasks and overseeing their work while they were in school.

Upon S Corp’s incorporation, Sons became employees of the S corporation, which issued them Forms W-2, Wage and Tax Statement, for the remaining audit years.[xxix]

Conclusion on Employee Status

These facts supported a finding of an employment relationship, as they demonstrated Taxpayer’s control over Sons’ work, his investment in the business, a lengthy employment relationship, and an intention to create an employer-employee relationship.

The IRS did not appear to dispute the classification of Sons as employees for the period following the incorporation of S Corp. Rather, the IRS disputed the timing of their employment, asserting that such status did not commence with the predecessor sole proprietorship. In support of this contention, the IRS cited Taxpayer’s failure to file Forms W-2 for that period.

To be sure, the Court acknowledged that the failure to file information returns may undermine the assertion of a bona fide employer-employee relationship.  In this case, however, the Court found that Taxpayer’s credible testimony was supported by contemporaneous evidence. The Plan, which was prepared in before the years in question, stated: “You [Taxpayer] have 2 children. The children work in the business.” Thus, under the particular circumstances of this case, the Court found it more likely than not that Sons were Taxpayer’s employees.[xxx]

Because the IRS did not dispute Taxpayer’s pension and profit-sharing deduction on any ground besides Sons’ employment status, the Court held that Taxpayer was entitled to the deduction.[xxxi]

Rent Expense

S Corp also claimed deductions for rent paid to Taxpayer for the use of their residential properties during the years in issue. The IRS fully disallowed those deductions, contending that S Corp’s reported rental expenses were not ordinary and necessary expenses paid or incurred in carrying on a trade or business. 

The Court agreed with the IRS.

The Code permits a taxpayer to deduct all ordinary and necessary expenses paid during the taxable year in carrying on its trade or business, including “rentals or other payments required to be made as a condition to the continued use or possession” of property.[xxxii]

In determining whether the payments in issue were deductible as ordinary and necessary business expenses, the Court stated, the basic question was whether the payments were in fact rent and not something else disguised as rent.  This is a question of fact, the Court explained, “and the character of the payments in question is to be judged in light of (1) all the terms and conditions of the agreement establishing the obligation to pay and (2) all the facts and circumstances existing at the time the agreement was made.” 

Moreover, only the portion of an expense that is reasonable qualifies for deduction.[xxxiii]  “The reasonableness concept has particular significance,” the Court stated, in determining whether payments between related parties represent ordinary and necessary expenses. 

Because Taxpayer wholly owned S Corp, the Court next considered whether the rental arrangement between the two was reasonable.

After what it described as a careful review of the record, the Court found it more likely than not that S Corp’s payments to Taxpayer were unreasonable and represented something other than rent.

The Court described Taxpayer’s rental arrangement with S Corp as another tax reduction strategy Consultant had suggested in the Plan. In making that suggestion, Consultant advised Taxpayer to use a reasonable rental rate supported by independent comparables. Consultant also suggested that Taxpayer retain a professional appraiser to determine fair rental values for the properties. Taxpayers did not follow that advice. Instead they charged S Corp the daily rental rates Consultant had assumed in its tax saving projections. Although Taxpayer contended that those rates were based on independent comparables, no such comparables appeared in the record. According to the Court, the absence of such comparables created a presumption that they would be unfavorable to Taxpayer. 

Taxpayer contended that the IRS’s full disallowance of S Corp’s rent deductions was arbitrary and capricious. According to Taxpayer, some portion of the rent must be deductible because the residential properties had fair rental values greater than zero. However, the record established that S Corp’s rental arrangement with Taxpayer was not reasonable. The Court added that while it may approximate a fair rental value in appropriate circumstances (under the Cohan Rule), it first had to have some factual basis upon which to make such an estimate. The Court pointed out that Taxpayer failed to provide any expert testimony or other evidence of the properties’ fair rental values. Accordingly, the Court was unable to conclude that any portion of S Corp’s reported rent expense was reasonable and, in turn, ordinary and necessary. Thus, the Court sustained the IRS’s disallowance of the rent deduction.


Let’s recap.

Taxpayer’s Plan was undertaken primarily, if not entirely, for tax saving purposes. It did not appear to have been motivated by any business goal. 

The Court properly subjected the transactions by and among Taxpayer, S Corp, C Corp, and Sons to close scrutiny to determine whether they were bona fide.

The Court agreed with the IRS’s disallowance of almost every deduction claimed by Taxpayer.

The Court found Taxpayer’s explanation of C Corp’s function was credible, but still found that C Corp did not perform any functions and was a sham.

The Court found Taxpayer’s testimony was credible and allowed the deduction in full for the amounts paid to Taxpayer’s Sons who were in college.

I find it difficult to reconcile the disallowed deductions described above from the compensation purportedly paid to Sons, for which a deduction was allowed. The latter was based in no small part upon the credibility of the Taxpayer’s testimony, while the former calls such credibility into serious question.

Family-owned and operated businesses are notorious for often paying unreasonable amounts of compensation to family members; i.e., amounts that exceed the fair market value of the services actually rendered by the family member.[xxxiv]

There are many reasons why family-owned businesses employ family members and sometimes pay unreasonable compensation for their services: to support a child, to enable a family member to participate in retirement and health plans, to make “gifts” as part of the owner’s estate planning, and, of course, to zero-out the employer-payor’s taxable income.

Whatever the motivation, the payment violates a basic precept: in a business setting, treat related parties on an arm’s-length basis as much as possible.

This simple rule accomplishes a number of goals. It supports the separateness of the corporate entity and the protection it affords from personal liability. It rewards those who actually render services, and may incentivize others to follow suit. It may cause those who are not productive to leave the business. It may reduce the potential for intra-family squabbling based on accusations of favoritism. And let’s not forget that it helps to avoid surprises from the IRS.

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The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] As I write this post, there are only 24 business days remaining in 2023.

[ii] Jadhav v. Commissioner, United States Tax Court, Filed, November 21, 2023.

[iii] To paraphrase Dickens, it may have been the product of “an undigested bit of beef, a blot of mustard, a crumb of cheese, a fragment of underdone potato.”

[iv] I’m partial to strawberry rhubarb (which, of course, is out of season), followed by apple.

As for pumpkin pie, I agree with Garrison Keillor’s assertion that “Pumpkin pie is a living symbol of mediocrity. The best pumpkin pie you ever ate wasn’t all that much different from the worst pumpkin pie you ever ate.”

[v] For reasons not disclosed, Taxpayer’s Spouse was named as the owner of Marketing on their tax returns. Has to make you wonder.

[vi] Consisting of the final tax year of the sole proprietorship and the three immediately succeeding tax years.

[vii] If Sons were truly employed by the family business at that time, query whether the foregone rent should have been treated as compensation to Sons for tax purposes. If so, would the total amount “paid” to Sons have been reasonable for the services actually rendered?

[viii] Pursuant to IRC Sec. 280A(g). Under this provision, if a dwelling unit is used during the taxable year by the taxpayer as a residence and such dwelling unit is actually rented for less than 15 days during the taxable year, then no deduction otherwise allowable under this chapter because of the rental use of such dwelling unit shall be allowed, and the income derived from such use for the taxable year shall not be included in the gross income of such taxpayer under IRC Sec. 61.

[ix] Good advice.

[x] You can’t make this up.

[xi] The Plan also included an unsigned legal opinion from an attorney stating: “We have determined that in the event that the taxpayer is challenged by the IRS, it is more likely than not that the taxpayer will be entitled to the income tax benefits described” in the Plan. That conclusion, however, had several caveats. For one, the attorney gave “no opinion as to the fair market value of any item for any deduction or credit taken.” In addition, the attorney made “no representation as to the reasonableness of any item” and “assumed there is a substantial and proper business purpose for each component of the tax plan, the structure of any entities, and the participation of any persons.”

[xii] IRC Sec. 1362.

[xiii] In the Plan, Consultant advised petitioners against owning more than 50% of C Corp, and recommended that Taxpayer find two unrelated individuals to hold 96% of the C corporation’s shares.

[xiv] I almost feel sorry for Taxpayer. Almost.

[xv] The line on an income tax return for “other deductions” is where some tax preparers will place more questionable items (which are often described in ambiguous terms).

[xvi] Presumably in accordance with the Sch. K-1 issued by S Corp.

[xvii] Pursuant to IRC Sec. 280A(g).

[xviii] Taxpayer treated C Corp’s payment of several personal expenses as nontaxable fringe benefits. The IRS did not challenge Taxpayer’s treatment of such payments. Go figure.

[xix] Taxpayer’s Form 1040, especially Sch. C; S Corp’s Form 1120-S; C Corp’s Form 1120.

[xx] An S corporation, like a partnership, is a flowthrough entity; its income and losses flow through to its shareholders, who then pay income tax. IRC Sec. 1363(b). IRC Sec. 1366 provides that an S corporation shareholder determines their tax liability by taking into account their pro rata share of the S corporation’s income, losses, deductions, and credits for the S corporation’s taxable year ending with or in the shareholder’s taxable year.

[xxi] For the period preceding the incorporation of S Corp.

[xxii] In fact, the IRS refunded the amounts C Corp paid as federal income tax for those years.

[xxiii] The Court found that Taxpayer failed to establish by adequate records or other sufficient evidence each element of the reported travel expenses required under IRS Sec. 274(d). Thus, the Court sustained the IRS’s determination on this issue.

The Court also agreed with the IRS’s disallowance of the marketing fees claimed by Taxpayer. The Court found that C Corp did not make any marketing expenditures for S Corp as suggested under the Plan. Nor did C Corp host meetings on S Corp’s behalf. Nevertheless, S Corp paid large yearly sums to C Corp, which, in turn, used those sums to pay the personal expenses of the Family. In the light of these facts, the Court found “it more likely than not that [C Corp] did not provide ordinary and necessary marketing services to [S Corp].”

Acknowledging that C Corp did not provide traditional marketing services to S Corp, Taxpayer nevertheless contended that the fees were ordinary and necessary for purposes of “risk mitigation.” At trial Taxpayer testified that the C Corp was used to develop new ideas, many of which would fail. According to Taxpayer, C Corp shielded S Corp from the “reputational risk of such failures.” Taxpayer testified that once an idea proved viable, S Corp would market it to potential users.

Although the Court found Taxpayer credible (I have my doubts about Taxpayer), it noted that Taxpayer did not explain how the marketing fees were determined. It was also unclear whether C Corp developed any ideas that warranted S Corp’s payments of large annual marketing fees. 

[xxiv] IRC Sec. 162.

[xxv] IRC Sec. 6001; Reg. Sec. 1.6001-1(a).

[xxvi] The Cohan Rule, under which a taxpayer who does not have records of actual expenditures by which to substantiate a deduction claimed on their return may instead rely on reasonable estimates for which there is a factual basis. See Cohan v. Comm’r, 39 F. 2d 540 (2d Cir. 1930). (“Absolute certainty in such matters is usually impossible and is not necessary; the Board should make as close an approximation as it can, bearing heavily if it chooses upon the taxpayer whose inexactitude is of his own making.”)

[xxvii] IRC Sec. 404(a).

[xxviii] For example, a disguised gift.

[xxix] Son-1 was a full-time employee of S Corp at the time of trial.

[xxx] The IRS contended that Sons were absent from trial and that the IRS was entitled to a presumption that their testimony would be unfavorable to Taxpayer.  The Court, however, responded that where both parties have equal access to the evidence, it will not apply an adverse inference.  The IRS, it stated, could have subpoenaed Sons; thus both parties had equal access to the potential witnesses. Therefore, the Court declined to draw a negative presumption against Taxpayer on this issue.

[xxxi] For example, it appears the IRS did not question whether the amounts paid to Sons as wages were unreasonable or excessive for the services rendered. IRC Sec. 162(a)(1) allows a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered.”

In some cases, the amount deemed excessive may be treated and taxed as a gift. Transfers reached by the gift tax are not confined to those only which, being without a valuable consideration, accord with the common law concept of gifts, but embrace as well sales, exchanges, and other dispositions of property for a consideration to the extent that the value of the property transferred by the donor exceeds the value in money or money’s worth of the consideration given therefor.

However, a sale, exchange, or other transfer of property made in the ordinary course of business (a transaction which is bona fide, at arm’s length, and free from any donative intent), will be considered as made for an adequate and full consideration in money or money’s worth. Reg. Sec. 25.2518-8.

[xxxii] IRC Sec. 162(a)(3).

[xxxiii] Again, query why this wasn’t raised with respect to the compensation.

[xxxiv] So-called “reasonable compensation” is determined by comparing the amount that would be paid for like services by like enterprises under like circumstances.