The New York City Tax Appeals Tribunal (“Tribunal”) agreed with an Administrative Law Judge decision that payments made to a domestic international sales corporation (DISC) were not deductible for purposes of the city’s unincorporated business tax.
In the Matter of Skidmore, Owings & Merrill LLP1 (“Skidmore”), the taxpayer is an architectural and engineering firm organized as a New York limited liability partnership during the years at issue. Skidmore had 14 equity partners and seven retired partners receiving retirement payments. Skidmore formed a DISC to receive qualified export receipts for professional services provided outside the United States. Skidmore, Owings and Merrill DISC, Inc. (S-DISC) made an election to be treated as an interest charge DISC and small business corporation for federal income tax purposes.
The purpose for forming S-DISC was to enable partners of Skidmore, who were also shareholders of S-DISC, to receive a portion of their compensation as qualified dividends taxable at a lower federal income tax rate. Skidmore paid commissions to S-DISC on a portion of the qualified export receipts from the performance of certain designated services and deducted the commissions paid on its federal partnership return. This deduction reduced the partners’ share of profits from Skidmore and transferred those profits to S-DISC for distribution to the shareholders of S-DISC as dividends taxed at a lower federal income tax rate.
The Tribunal also found that payments to S-DISC represented partner compensation for redistribution to partners in differing percentages. Partner A, Partner B, and Partner C owned 56.5% of stock in S-DISC together but only held a 21% profits interest in Skidmore. The remaining partners-shareholders held only 43.5% of the shares of stock in S-DISC but held a 79% profits interest in Skidmore. This commission redistribution arrangement supported the Tribunal’s decision that the purpose of S-DISC was an arrangement for partner compensation and that the payments were for partner services, therefore, not deductible for purposes of the unincorporated business tax.
Lesson: This is a case where the substance of the transaction prevailed over the form of the transaction, despite the federal sanction of the use of a DISC. By their very nature, DISCs do not usually employ individuals, yet just following the federal rules did not result in the desired state tax treatment. In general, taxpayers should make sure their transactions have business substance and purpose to retain the planned benefits. Our Ryan income tax professionals can assist in making sure that business substance and purpose drive a transaction and structure to maintain a planned benefit.
1 [TAT (E) 17-21 (UB)].
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