Dental Practice’s Management Fees Were Not Ordinary and Necessary Business Expenses

By Anne Chang, CPA, MBA, MST, Irvine, Calif.

Editor: Mark G. Cook, CPA, MBA, CGMA

In May 2016, the Supreme Court declined to review a decision of the Ninth Circuit that denied deductions for management fees claimed by a dental practice as ordinary and necessary business expenses within the meaning of Sec. 162 (Elick, 638 Fed. Appx. 609 (9th Cir. 2016), aff'g T.C. Memo. 2013-139). The Ninth Circuit had affirmed the Tax Court's decision that the management fees were unnecessary because the taxpayer did not provide proof to show that any services were actually performed in exchange for the fees, and thus the taxpayer could not deduct them.


At the times relevant to the case, Wiley M. Elick DDS Inc. was a dental practice. Dr. Wiley Elick and his wife, Sharon Elick, were the practice's sole shareholders and board members, and they were both salaried employees. The practice also employed a bookkeeper/office manager, who was also paid a salary.

In 2002, Dr. Elick consulted with what the Tax Court called a "professional" who advised him to set up a company to manage the practice's operations. Thus, Dr. Elick started a company, SD Management Group Inc. (SDG), for this purpose, which established an employee stock ownership plan (ESOP) to benefit the practice's employees. The ESOP purchased all of the SDG stock from Dr. Elick, who was SDG's sole owner, officer, and board member.

SDG and the practice then entered into an agreement to manage the practice's operations (management agreement). SDG agreed to produce annual capital, operating, and cash flow budget plans; investigate and document customer complaints; develop policies and procedures; recruit, supervise, and train the practice's employees; perform fiscal services; and ensure regulatory compliance. In exchange, the practice agreed to pay SDG management fees ranging from 1% to 25% of its monthly gross receipts within 20 days of month end. SDG did not have any paid employees during 2005 and 2006. Dr. Elick entered into an employment agreement to be a "co-employee" of both the practice and SDG.

Dr. Elick practiced dentistry full time for the practice during 2005 and 2006, and the bookkeeper continued to work full time and performed many of the functions that SDG was to provide. The practice paid SDG management fees of $430,000 for 2005 and $303,000 for 2006. These amounts were determined by Dr. Elick.

On its Forms 1120, U.S. Corporation Income Tax Return, for 2005 and 2006, the practice claimed business expense deductions for the management fees. The IRS issued deficiency notices to the practice disallowing the management fee deductions and imposing accuracy-related penalties.


Generally, a taxpayer may deduct ordinary and necessary business expenses paid or incurred during the tax year in carrying on a trade or business (Sec. 162(a)). Deductions of business expenses are a matter of legislative grace. Taxpayers must satisfy the specific statutory requirements for the item claimed. Whether an expense satisfies Sec. 162 is generally a question of fact.

An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a common or frequent transaction in the type of business involved. A necessary expense is appropriate and helpful to the operation of the taxpayer's trade or business. The court had found management fees to be ordinary and necessary expenses in some circumstances (see, e.g., Wy'East Color, Inc., T.C. Memo. 1996-136). A taxpayer must demonstrate that management services were actually rendered (Regs. Sec. 1.162-7; see also ASAT, Inc., 108 T.C. 147, 174—175 (1997)). A necessary expense need not be absolutely essential (see Haskel Eng'g & Supply Co., 380 F.2d 786, 788—789 (9th Cir. 1967)). However, the amount must be reasonable. The reasonableness concept has particular significance in dealings between related parties (Fuhrman, T.C. Memo. 2011-236).

Under Secs. 6662(b)(1) and (2), a taxpayer is liable for an accuracy-related penalty on any part of an underpayment attributable to, among other things, negligence or a substantial understatement of income tax. Negligence is defined as any failure to make a reasonable attempt to comply with the provisions of the Code or to exercise ordinary and reasonable care in the preparation of a tax return. However, if a taxpayer acted with reasonable cause and in good faith with respect to any portion of the underpayment, he or she is not liable for an accuracy-related penalty (Sec. 6664(c)(1)). The determination of whether a taxpayer acted with reasonable cause and in good faith depends on the pertinent facts and circumstances, including the taxpayer's efforts to assess his or her proper tax liability; the taxpayer's knowledge, experience, and education; and reliance on the advice of a professional (Regs. Sec. 1.6664-4(b)(1)).


SDG agreed to provide various services to the practice. Before the execution of the management agreement, Dr. Elick and the bookkeeper/office manager performed many of the functions that were provided in the agreement. An outside payroll service was retained to provide payroll service and compliance training to the practice's employees. After the execution of the management agreement, Dr. Elick and the bookkeeper performed the same functions for the practice. Although Dr. Elick claimed that he was a "co-employee" of the practice and SDG, both he and the bookkeeper continued receiving Forms W-2, Wage and Tax Statement, from the practice during the years in question. SDG did not have records of Dr. Elick's and the bookkeeper's duties or the hours they performed management services. SDG never compensated Dr. Elick or the bookkeeper for the services they provided to the practice.

Although the management agreement required the practice to pay monthly management fees within 20 days of month end, the records showed that the practice paid SDG the fees at the end of its fiscal years. SDG issued no invoices to the practice in the two years at issue.

The court found that the practice's records indicated that it received management services from Dr. Elick, its bookkeeper, and a third party. However, it did not demonstrate that it received any services from SDG, as obligated by the management agreement. The records provided by the practice showed no correlation between the $733,000 in management fees and the services allegedly performed. The court found that the practice did not establish that any management fees were necessary or reasonable and, therefore, sustained the IRS's determination that the management fees were not deductible.

Dr. Elick argued that the accuracy-related penalty should not apply because he relied on the advice of a professional. The court found that Dr. Elick established SDG and the ESOP with the professional's assistance. However, the court also noted that Dr. Elick determined the amounts of the management fees and provided them to the practice's tax return preparer, and the practice failed to provide credible evidence that it received services in exchange for the management fees and to show that it respected the terms of the management agreement. The court concluded that the mere fact that the overall structure was suggested by a professional was insufficient to establish reasonable cause and, therefore, held that the practice was liable for the accuracy-related penalty.


In this case, the taxpayer relied on the advice of a professional to set up the management company and the ESOP. However, mere setup of the business entity and execution of the management agreement were not sufficient to support the business expense. For the taxpayer to establish that the management fees were necessary and reasonable, the management company needed to provide services according to the management agreement and to show a correlation between the management fees and the services performed.


Mark Cook is the lead tax partner with SingerLewak LLP in Irvine, Calif.

For additional information about these items, contact Mr. Cook at 949-261-8600 or

Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.

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