In the case of Aspro v. Commissioner, Case No. 21-1996, CA8,[1] the Eighth Circuit Court of Appeals sustained the Tax Court’s disallowance of a deduction of management fees paid to shareholders of a C corporation and the treatment of the payment as disguised distributions taxable as dividends.

There are various reasons why some closely held entities make payments to related parties that are labeled management fees. In this case we aren't told what the ultimate goal was of such fees, but we do know that they had continued for an extremely long period of time.

The opinion summarizes the facts of the case as follows:

Aspro, Inc. is an asphalt-paving company in Waterloo, Iowa. It is incorporated under Iowa law and treated as a subchapter C corporation for federal income-tax purposes. Between 2012 and 2014, the relevant years, Aspro stock was held by: Milton Dakovich, the president of Aspro; Jackson Enterprises Corp.; and Manatt’s Enterprises, Ltd. Aspro has not paid dividends since the 1970s but, except for one year, has paid its shareholders “management fees” for at least twenty years. In addition to receiving management fees, Dakovich received a salary, director fees, and bonuses for each of the relevant years. There were no written agreements between Aspro and its three shareholders regarding fees paid for management services, nor was there an employment contract between Aspro and Dakovich. Aspro claimed deductions on its tax returns for management fees for tax years 2012 through 2014.[2]

The IRS examined the corporation’s returns and denied the deduction for management fees, finding that the corporation had failed to establish that it had incurred or paid these fees for ordinary and necessary business purposes as required by IRC §162. Rather the IRS found that these payments represented disguised distributions being paid to the corporation’s shareholders. The taxpayer filed a petition in the Tax Court challenging these findings of the IRS, but the Tax Court ruled in the IRS’s favor. The taxpayers then appealed that decision to the Eighth Circuit Court of Appeals.

The Underlying Law for Deductibility of Such Management Fees

The panel’s opinion begins by discussing the general rules for allowing a deduction for trade or business expenses of a corporation.

…[W]e consider Aspro’s challenge to the tax court’s holding that none of the management fees paid by Aspro was deductible because they were instead disguised distributions of profits. See United States v. Ellefsen, 655 F.3d 769, 779 (8th Cir. 2011) (explaining that distributions of profits are not deductible). Whether payments made to shareholders are distributions of profits rather than compensation for services is a factual determination. Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d 193, 194-95 (8th Cir. 1952). We review the tax court’s factual determinations for clear error and “must affirm unless left with a conviction that the tax court has committed a mistake.” Keating v. Comm’r, 544 F.3d 900, 903 (8th Cir. 2008). We consider all the facts and circumstances when determining whether the compensation paid to a corporation’s shareholders is actually a distribution of profits. See Heil Beauty Supplies, 199 F.2d at 195; Charles Schneider & Co. v. Comm’r, 500 F.2d 148, 151 (8th Cir. 1974). Aspro bore the burden of proving its entitlement to the deductions. See T.C.R. 142(a)(1).[3]

The panel discusses the differences between deductible business payments for a C corporation and amounts that represent distributions to the shareholders, including how to determine if an amount paid that claims to be for a business expense is actually a disguised distribution, structured in this manner to avoid the less favorable tax treatment of paying a distribution. That is, the negative tax consequence that the C corporation will get no deduction for this payment while it will still be taxable income to the shareholders:

Corporations must pay federal income tax on their taxable income, 26 I.R.C. § 11(a), which is gross income less allowable deductions, § 63(a). Under § 162(a)(1), deductions are allowed for expenses that are “ordinary and necessary” in carrying on a trade or business, including “reasonable allowance for salaries or other compensation for personal services actually rendered.” “Ordinary has the connotation of normal, usual, or customary,” and describes expenses arising from transactions “of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940). Necessary means appropriate and helpful to the development of the business. See Comm’r v. Heininger, 320 U.S. 467, 471 (1943); Welch v. Helvering, 290 U.S. 111, 113 (1933).

“As the language of § 162(a)(1) suggests, a deduction may be made if salary is both (1) ‘reasonable’ and (2) ‘in fact payments purely for services.’” David E. Watson, P.C. v. United States, 668 F.3d 1008, 1018 (8th Cir. 2012) (quoting Treas. Reg. § 1.162–7(a)); see also Wy’East Color Inc. v. Comm’r, 71 T.C.M. (CCH) 2501, 1996 WL 119492, at *6 (1996) (“A taxpayer may deduct payments for management services under section 162 if the payments are for services actually rendered and are reasonable in amount.”). “Usually, courts only need to examine the first prong,” although “in the rare case where there is evidence that an otherwise reasonable compensation payment contains a disguised dividend, the inquiry may expand into compensatory intent apart from reasonableness.” David E. Watson, 668 F.3d. at 1018 (brackets omitted). However, “[t]he inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into compensatory intent in most cases.” Id. In general, reasonable compensation is limited to “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” Treas. Reg. § 1.162-7(b)(3); see also Home Interiors & Gifts, Inc. v. Comm’r, 73 T.C. 1142, 1155-56 (1980).

“[C]orporations are not allowed a deduction for dividends paid to the shareholders,” Ellefsen, 655 F.3d at 779, including distributions that are disguised as compensation. Treas. Reg. § 1.162-7(b)(1); Charles Schneider, 500 F.2d at 152-53. Compensation paid by the corporation to shareholders is closely scrutinized to make sure the payments are not disguised distributions. Heil Beauty Supplies, 199 F.2d at 194 (“Any payment arrangement between a corporation and a stockholder . . . is always subject to close scrutiny for income tax purposes, so that deduction will not be made, as purported salary, rental or the like, of that which is in the realities of the situation an actual distribution of profits.”).[4]

As well, the panel notes how the law is applied to determine if compensation (in whatever form) being paid to the shareholders is reasonable, as required under IRC §162:

To determine whether compensation paid to a shareholder-employee is reasonable, courts consider factors enumerated in Charles Schneider, 500 F.2d at 151-52.6 No single factor is dispositive; rather, the court is to base its decision on a careful consideration of applicable factors in light of the relevant facts. See Mayson Mfg. Co. v. Comm’r, 178 F.2d 115, 119 (6th Cir. 1949). Because the factors in isolation offer insufficient guidance on their application, we view them in the context of the list as a whole.[5]

Why the Taxpayer Failed to Show These Were Deductible Business Expenses

The panel agreed with the Tax Court and the IRS that the taxpayer had failed to demonstrate these payments represented deductible business expenses under IRC §162. The panel pointed out a number of problems with these payments, problems that probably aren’t all that unusual for many of the taxpayers that attempt to payout such management fees.

The panel begins by noting:

Aspro did not present evidence showing what “like enterprises under like circumstances” would ordinarily pay for like management services. See Treas. Reg. § 1.162-7(b)(3). It also did not quantify the value of the management services provided, nor did it show that similar companies would pay that amount for similar services.[6]

The lack of any written agreement between the parties or any methodology being documented that was used to compute the amount of these management fees was also a major problem in the view of the panel:

As the tax court noted, Aspro produced no written management-services agreement or other documentation of a service relationship between Aspro and either entity, no evidence of how Aspro determined the amount of the management fees, and no evidence that either entity billed Aspro or sent invoices for any services performed for Aspro. See ASAT, Inc., v. Comm’r, 108 T.C. 147 (1997) (holding that the taxpayer was not entitled to deduct consulting fees where there were no written agreements, no documentation providing how the management fees were calculated, and billing invoices containing almost no details); Fuhrman v. Comm’r, 102 T.C.M. (CCH) 347 2011-236, 2011 WL 4502290, at *2-3 (same).[7]

The nature of the actual payments appeared much more consistent with payments being made to the shareholders as a return based on their ownership interest in the corporation, something we’d normally refer to as a dividend payment:

Further, we agree with the tax court that the management fees paid by Aspro to Jackson Enterprises Corp. and Manatt’s Enterprises, Ltd. were not purely for services rendered and were instead disguised distributions of profits. See David E. Watson, 668 F.3d. at 1019. Aspro has made no dividend distributions since the 1970s but has paid management fees every year but one for twenty years. See Paul E. Kummer Realty Co. v. Comm’r, 511 F.2d 313, 315 (8th Cir. 1975) (“[T]he absence of dividends to stockholders out of available profits justifies an inference that some of the purported compensation really represented a distribution of profits as dividends.”); Charles Schneider, 500 F.2d at 153 (“Perhaps most important [in identifying disguised distributions] is the fact that no dividends were ever paid by any of these companies during [this time], even though they enjoyed consistent profits and immense success in the industry.”).[8]

In addition to the fact that dividends never had been paid, the court noted that the actual amount in management fees seemed to be roughly in line with the percentage of ownership interest of the various owners. Again, this is more like something we would expect to see in the payment of dividends then we would for payments based on the value of services actually rendered:

And Aspro has also paid management fees in amounts roughly proportional to the ownership interests of the stockholders. Jackson Enterprises Corp. and Manatt’s Enterprises, Ltd. each owned forty percent of Aspro’s stock, and each received forty-three percent of the total management fees paid in 2012, forty-six percent in 2013, and forty-four percent in 2014. See Paul E. Kummer, 511 F.2d at 316 (suggesting that payments to shareholders that were “almost identical” to their ownership interest indicated disguised distributions); Treas. Reg. § 1.162-7(b)(1) (stating that a disguised distribution is likely where “excessive payments correspond or bear a close relationship” to ownership interests); RTS Inv. Corp. v. Comm’r, 53 T.C.M. (CCH) 171, aff’d, 877 F.2d 647 (8th Cir. 1989) (per curiam). The district court correctly found that Aspro had a “process of setting management fees [that] was unstructured and had little if any relation to the services performed” and “had relatively little taxable income after deducting the management fees,” and Aspro does not dispute that it paid the management fees as lump sums at the end of the tax year even though many of the services that Aspro claims justified the management fees were performed throughout the year. See Nor-Cal Adjusters v. Comm’r, 503 F.2d 359, 362-63 (9th Cir. 1974) (affirming in a disguised-distribution context the tax court’s reliance on factors including an unstructured process of setting shareholder compensation, consistently negligible taxable income, and lump-sum payments to shareholders). Therefore, the tax court did not clearly err in concluding that the management fees paid to Jackson Enterprises Corp. and Manatt’s Enterprises, Ltd. were nondeductible because Aspro failed to carry its burden of showing that the fees were reasonable and purely for services.[9]

The corporation also failed to show that overall amounts paid to the shareholders for their salaries, bonuses, directors fees and management fees represented reasonable amounts of compensation to the shareholders for services actually rendered:

We conclude that the district court did not clearly err in finding that Aspro failed to meet its burden to show that the management fees paid to Dakovich “would ordinarily be paid for like services by like enterprises under like circumstances.” See Treas. Reg. § 1.162-7(b)(3); Home Interiors, 73 T.C. at 1155-56. Aspro did not present evidence showing what similar companies under like circumstances would pay as management fees (over and above salary and bonuses) to an employee like Dakovich for the same type of management services. It also did not quantify the value of the management services he provided, nor did it show that like enterprises would pay that amount for them. In fact, the Commissioner’s expert said the exact opposite. Nunes, an expert in valuing compensation arrangements, reviewed deposition transcripts about the services Dakovich provided to Aspro and determined the amount of reasonable compensation that a comparable enterprise would have to pay in the marketplace for the services described in the depositions. He concluded that Dakovich’s salary and bonus exceeded the industry average and median by a substantial margin and that management fees in addition to the salary and bonus were not reasonable. When Nunes added Dakovich’s excess compensation per year to his management fees, his share of the total management fees over the three years at issue was twenty-two percent, closely aligning with his twenty-percent ownership interest in Aspro; the other two shareholders each received thirty-nine percent, which closely aligned with their approximately forty-percent-each ownership interest in Aspro.[10]

The panel also concluded, not surprisingly, that these payments did not constitute reasonable compensation to the shareholders:

Factors discussed in Charles Schneider strengthen our conclusion that the district court did not clearly err, including “the absence of profits paid back to the shareholders as dividends”; “the nature, extent and scope of the employee's work”; and “a most significant factor,” “the prevailing rates of compensation for comparable positions in comparable concerns.” See Charles Schneider, 500 F.2d at 152-54.[11]

Rather the panel concludes the facts lead to the conclusion that these payments are far more likely to be distributions of corporate profits to the equity holders, something that is not deductible at the corporate level:

Aspro has not paid any dividends to stockholders since the 1970s, but regularly pays management fees. This “justifies an inference that . . . the purported compensation really represents a distribution of profits.” See id. at 153.[12]

The court also noted that these fees were always paid at the end of the year, and generally brought the corporations taxable income down to a relatively small amount:

As with Jackson Enterprises Corp. and Manatt’s Enterprises, Ltd., Aspro paid the management fees as lump sums at the end of the tax year even though the purported services were performed throughout the year, had an unstructured process of setting the management fees that did not relate to the services performed, and had a relatively small amount of taxable income after deducting the management fees. See Nor-Cal Adjusters, 503 F.2d at 362-63. Therefore, the tax court did not clearly err in finding that Aspro failed to carry its burden of showing that the management fees were reasonable and purely for services actually performed.[13]

Lessons from This Case

Advisors can take a number of lessons from studying this case. One of the key ones actually has little to do with the issue at hand, but rather to something that's often used to justify taking positions that the advisor should be aware would be unlikely to survive any sort of review by a taxing agency.

As the panel noted, the corporation had gotten away with making these disguised dividend payments for two decades before the IRS finally examined the corporation and raised the issues. The fact that the IRS had never challenged this before, or, as clients often love to tell their tax advisor, other taxpayers have been doing this for decades and never had an issue, is of no use once the challenge is brought forth. Note that the court never even vaguely considered allowing the taxpayer to claim this deduction merely because it had gone unchallenged for so long.

Second, it is important to carefully document anything dealing with a payment to a related party where the IRS may gain advantage by restructuring that payment under a different view. The lack of any sort of documentation regarding how these management fees had been computed allowed the IRS to easily persuade the court it was likely they were being paid to bail out earnings from the corporation to avoid having a double tax situation eventually, where amounts were going to be taxed at the corporate level and later taxed when distributed to the shareholders. Even worse, there wasn’t even the very basic type of documentation regarding the nature of the agreement or what exactly the services were that were to be performed in order to earn these management fees.

The fact that payments were made solely in a lump sum at the end of the year also helped the IRS persuade the court that this was such a tool being used solely to reduce taxable income in the corporation, not an actual payment related to services being rendered to the corporation.

Again, it's important to note that the taxpayers had years of what they believed was IRS acceptance of this sort of a program. But reality is that the IRS doesn't look at most returns in any detail, even when claiming deductions for things like management fees that you might think could raise some issues. And it's also important to note that the fact you got away with it for 20 years is no defense whatsoever in a year in which the agency decides to ask about the item.

Advisors need to realize that even though this corporation got away with this for 20 years, advisors working with a large number of taxpayers are going to be far more exposed to the IRS running into the issue on one or more of their clients.

So the advisor is far more exposed than any individual client to potentially bad results arising from such sloppy and aggressive tax positions being taken. Such bad results can arise from the IRS taking action against the preparer, but more likely the advisor’s client will suddenly be “shocked” to discover that this position was aggressive, regardless of how hard they may have pushed for it or how much they whined that all of their friends and business acquaintances were doing the same thing and they wondered why the advisor was being such a wimp about these matters. That may result in the client either filing a civil claim against the tax advisor or filing a complaint with a licensing agency.

[1] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022, https://www.taxnotes.com/research/federal/court-documents/court-opinions-and-orders/eighth-circuit-affirms-manager-fees-were-disguised-distributions/7df6s (retrieved April 27, 2022)

[2] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[3] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[4] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[5] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[6] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[7] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[8] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[9] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[10] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[11] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[12] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022

[13] Aspro v. Commissioner, Case No. 21-1996, CA8, April 26, 2022