This time it’s IRS, not Kenton R. Bowen, et. al., Docket No. 2215-24, filed 9/25/26, that’s party to a divorce. Judge Ronald L. (“Ingenuity”) Buch goes off the bench finding IRS proposed “recharacterization would result in tax consequences that are divorced from the economics.” Transcript, at p. 18.
Ken and buddy Scott ran a concert promo outfit fittingly named PromoWest. In case they sold PromoWest to nonpromoters, they created SSKB, LLC, a passthrough to provide management services to PromoWest. PromoWest paid management fees to SSKB when it had cash. PromoWest was promoting and seeking new venues in the Midwest, but like all promoters it was chronically short of cash. Ken and Scott landed a deal with a bank, which loaned money to SSKB but required SSKB to make distributions to Ken and Scott, who of course personally guaranteed payment and performance of the loan terms.
PromoWest, SSKB, and Ken and Scott all reported as written.
“Everyone treated this series of transactions consistently for tax purposes. PromoWest deducted the management fees it paid to SSKB. SSKB reported the management fees it received as income, including those management fees that were redirected to loan repayments. SSKB treated the loan as a loan, in other words, it did not take the loan proceeds into income and it did not deduct any repayments of principal. [Scott and Ken] reported their shares of income from SSKB, which included the management fees paid by PromoWest.” Transcript, at pp. 8-9.
Finally, Ken and Scott sold PromoWest to another promoter who didn’t need a management arm, so SSKB was dissolved and paid off the loan in the same year.
IRS gets creative. “Taken together, the gist of the Commissioner’s adjustments is that he recharacterizes $6 million of the loans to SSKB as a dividend from PromoWest to [Scott and Ken]. The Commissioner treats the dividend as taxable to [Scott and Ken] and non- deductible to PromoWest. If loan proceeds distributed to [Scott and Ken] were actually a dividend from PromoWest, then the loan must have really been made to PromoWest. So the Commissioner’s notices determine that PromoWest ‘was in substance the true debtor with respect to [the] Loans.’ And if the loans were in substance made to PromoWest, then the loan repayments must have come from PromoWest. To reach this result, the Commissioner disallows the management fee deduction claimed by PromoWest, but instead, allows an interest expense deduction to PromoWest. For consistency, the Commissioner reduces SSKB’s income for the now-disallowed management fee.” Transcript, at p. 10. And at trial, IRS claims the management fees paid to SSKB weren’t ordinary and necessary, so no Section 162 treatment for those.
IRS says substance over form. Ken and Scott say they can structure their business however they want, but must stick to the structure, and they did.
As for the management fees, SSKB provided them. IRS says Ken and Scott should have been deemed to have provided them directly. OK, says Judge Ingenuity Buch, that might support recharacterizing, but not deductibility.
Substance over form means sussing out the economics. Cherchez les bucks. Here there were management fees, loans, and loan repayments. On all counts, Ken’s and Scott’s reporting more closely aligned with what they did rather than IRS’ convoluted ballet.
“PromoWest paid for the services of {Ken and Scott]. It received a deduction for the payments made for those services. Whether paid as a salary or a management fee, the consequences would have been the same to PromoWest, a deduction. And the consequence was the same to [Ken and Scott]. Whether received as a salary or as a share of partnership income, it would have been ordinary income to each of them. And this is how they reported it on each of their returns. Petitioners’ form, economics, and tax treatment all aligned.” Transcript, at p. 15.
IRS’ “dividends” argument founders on E&P. Dividends come out of E&P and are paid for specific years, not all in a lump, and here there’s no such link. “The Commissioner’s proposed recharacterization makes no economic sense.” Transcript, at p. 15.
IRS’ treatment of the loan and repayment thereof earns them a Taishoff “Oh Please, First Class.” And a blow-off from Judge Ingenuity Buch.
“The Commissioner’s recharacterization would treat the loan as being a loan to PromoWest, with $6 million of the proceeds deemed to be a dividend to [Ken and Scott]. But SSKB was liable for the loan, and SSKB’s owners are [Ken and Scott]. Under the Commissioner’s recharacterization, [Ken and Scott] would be taxed on the loan proceeds for which they remain liable. This is contrary to the principle that loan proceeds arenot taxable. The Commissioner’s recharacterization would result in tax consequences that are divorced from the economics.” Transcript, at pp. 17-18.
As for repayments, IRS fumbles that one, too.
“Petitioners’ form is consistent with the economics of a loan repayment. In form, SSKB paid interest and repaid the loans from its income and assets. What appears to concern the Commissioner is that the income used to make the loan repayments came from PromoWest. Indeed, PromoWest made the loan repayments on behalf of SSKB. But both economically and for tax purposes, PromoWest treated the loan repayments as amounts paid to SSKB in satisfaction of PromoWest’s obligation to pay management fees. Consistent with that treatment, SSKB took those payments into income. The Supreme Court acknowledged the economic effect of an arrangement such as this nearly a century ago. ‘The discharge by a third person of an obligation to him is equivalent to receipt by the person taxed.’ Old Colony Tr. Co. v. Commissioner, 279 U.S. 716, 729 (1929). Petitioners’ form, economics, and tax treatment are consistent.” Transcript, at pp. 18-19.
True, IRS’ recharacterization is streamlined, but more divorced.
“The Commissioner would treat the loan repayments as loan repayments by PromoWest, without the added step of deeming these to be management fees to SSKB. As loan repayments, the Commissioner would neither tax nor allow deductions for the repayments. But the loan repayments satisfy a loan to SSKB, which is owed by [Scott and Ken]. Because a third party (PromoWest) is reducing SSKB’s liability on those loans, the loan repayments are income to SSKB, and ultimately to [Scott and Ken]. Id. Thus, while streamlined, the Commissioner’s recharacterization would divorce the economics of what occurred from the tax consequences.” Transcript, at p. 19.
Judges always have the last word. Here’s Judge Ingenuity Buch. “Substance over form is a doctrine designed to cause the tax consequences to be aligned with the economic reality of what occurred. The Commissioner seeks to use it to do the opposite.” Transcript, at p. 20.
C. S. Lewis, thou should’st be living at this hour.
I am sure I need not ask whether Ken’s and Scott’s trusty attorneys, John, Harlan, and Nic, to whom I award a Taishoff “Good Job, First Class,” have already started on the Section 7430 admins-and-legals motion.
Edited to add, 9/25/26: Before my ultrasophisticated readers berate me for having forgotten the 18 USC §2412(d)(2)(B) net worth cutoff engrafted onto Section 7430(c)(4)(D), I have left a v/m with one of Ken’s and Scott’s trusty attorneys enquiring, and will publish any reply.
