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Company Loses Deductions for Pay of Exec Who Works for Another Company

To qualify for business-expense deductions, compensation payments must satisfy the “ordinary and necessary” requirement imposed by Code Section 162. The IRS cautions that this restriction should be kept in mind when a company assigns one of its executives to perform services for a related outfit.

Nov 25th 2019
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To qualify for business-expense deductions, compensation payments must satisfy the “ordinary and necessary” requirement imposed by Code Section 162. The IRS cautions that this restriction should be kept in mind when a company assigns one of its executives to perform services for a related outfit.

As a general rule, says the IRS, no deduction can be claimed by a company that pays an employee to do work for a different entity. The snag is that the payment by the company that foots the bill isn’t considered ordinary and necessary.

However, the IRS authorizes an exception to the general rule. Under the exception, a company is entitled to a deduction where it pays its own employee for services that the employee renders to a related company, provided the payor corporation is able to show that it directly benefits from specific activities performed by the employee.

Nevertheless, a Tax Court decision (Cropland Chemical Corporation, 75 TC 288, 1980) that was affirmed by the Seventh Circuit Court of Appeals (665 F. 2d 1050, 1981) makes clear that the payor company shouldn’t routinely assume that the exception assures a deduction merely because it clearly benefits from the services performed by the employee for the related enterprise.

This limitation on the exception was made expensively clear to two companies, Cropland and Morrison, that decided to form a joint venture. They dubbed it  Argo and decided that its general manager would be Trowbridge, Cropland’s principal officer and director.

Cropland and Morrison agreed that they were to equally split all of Agro’s income and expenses. Also, they agreed that Agro was to compensate Trowbridge for his services on behalf of the joint venture.

Trowbridge devoted his entire time to the venture. It became highly profitable. As a result, Cropland’s income increased.

Cropland decided to recognize Trowbridge’s service to Agro by paying him $286,000 for the two years in issue. It filed returns that deducted these amounts as compensation.

The IRS determined that the exception didn’t apply and disallowed the deductions. Cropland took the dispute to the Tax Court. It upheld the IRS’s disallowance, except for $10,000 in each of the two years. The court cited the venture agreement’s provision that only Agro was obligated to compensate Trowbridge for his services.

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