Payments to Shareholders Were Disguised Dividends, Not Deductible Management Fees

(Parker Tax Publishing February 2021)

The Tax Court held that a C corporation was not entitled to deductions for management fees paid to its three shareholders because the payments were disguised distributions. The court noted that the corporation never paid dividends to its shareholders and presented no evidence showing that an independent investor would have been satisfied with investment returns after shareholder compensation. Aspro, Inc. v. Comm'r, T.C. Memo. 2021-8.

Background

During 2012 - 2014, Aspro, Inc. (Aspro), a C corporation, operated an asphalt paving business in Waterloo, Iowa. Most of the company's revenue came from contracts with government entities. Aspro had three shareholders: Jackson Enterprises Corp. (owning 40 percent of the stock), Manatt's Enterprises, Ltd. (owning 40 percent of the stock), and Milton Dakovich (owning 20 percent of the stock). Stephen Jackson was the president of Jackson Enterprises Corp. and was also the president of a 98 percent owned subsidiary, Cedar Valley Corp. Another entity, Cedar Valley Management Corp., provided management services to Cedar Valley Corp. and employed Jackson and William Calderwood, among others, to provide those management services.

Manatt's Enterprises, Ltd., was engaged in a farming operation in Iowa. It was a subchapter C corporation and was not engaged in asphalt or road paving. Tim Manatt was its president. While Manatt did not have any formal training or education in investment management, he monitored and managed Aspro's Vanguard account. He took a buy-and-hold approach to investing in mutual funds. He did not actively trade funds and did not track his time spent monitoring Aspro's Vanguard account, nor did he bill or invoice Aspro for his services. There was no written agreement between Aspro and Manatt regarding his management of the Vanguard account.

During each year at issue the city of Waterloo had one alternate bid project on which both asphalt and concrete paving companies could bid to obtain the street paving contract. Aspro was the only bidder for these alternate bid projects and was awarded the project each year. Dakovich served as Astro's president and was responsible for Aspro's day-to-day management. Over the years, Dakovich routinely contacted Jackson and Calderwood for input on how a concrete paving company might bid on the alternate bid project that year. When asked to do so, Jackson and Calderwood would review the project plans for the alternate bid project and verbally communicate to Dakovich what bid a concrete paving company might propose for the project. Jackson had 35 years of experience bidding for concrete paving projects. Calderwood was in charge of bidding on concrete paving projects for Cedar Valley Corp. and prepared roughly 150 to 200 bids per year. He spent 5 to 10 hours helping Aspro with the Waterloo alternate bid project each year. During the years at issue, the city of Waterloo had one alternate bid project on which both asphalt and concrete paving companies could bid to obtain the street paving contract. Aspro was the only bidder for these alternate bid projects and was awarded the project each year.

Aspro paid management fees to each of the shareholders for the years at issue. Although the management fees paid were not exactly pro rata among the three shareholders, the two largest shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests.

Aspro did not enter into any written management or consulting services agreements with any of its three shareholders. No management fee rate or billing structure was negotiated or agreed to between the shareholders and Aspro at the beginning of any of the years in issue. None of the shareholders invoiced or billed Aspro for any services provided. Instead, Aspro's board of directors would approve the management fees to be paid to the shareholders at a board meeting later in the tax year, when the board had a better idea how the company was going to perform and how much earnings the company should retain. The board did not attempt to value or quantify any of the services performed by Manatt's Enterprises, Ltd., or Jackson Enterprises Corp. but instead approved a lump-sum management fee for each shareholder for each year. The management fees paid to each entity were always equal each year, even though the services provided might vary from year to year.

For 2012-2014, Aspro reported gross receipts and taxable income of approximately $25.9 million and $142,000, $22.5 million and $281,000, and $23.6 million and $524,000, respectively. For 2012-2014, Aspro deducted management fees of $1,166,000 ($166,000 to Dakovich and $500,000 each to Jackson Enterprises and Manatt's Enterprises), $1,750,000 ($150,000 to Dakovich and $800,000 each to Jackson Enterprises and Manatt's Enterprises), and $1,800,000 ($200,000 to Dakovich and $800,000 each to Jackson Enterprises and Manatt's Enterprises), respectively. Astro did not declare or distribute dividends to any of its shareholders during the years at issue or any prior years.

After auditing Aspro's 2012-2014 tax returns, the IRS denied the management fee deductions in full and assessed a deficiency. According to the IRS, the management fees were disguised distributions rather than deductible compensation for services. Aspro appealed to the Tax Court, arguing that the services provided by the shareholders justified the amount of the management fees paid.

Analysis

The Tax Court held that Aspro was not entitled to the management fee deductions for 2012-2014. The court concluded that Aspro failed to establish the nature, occurrence, and frequency of most of the services that it argued justified the management fees paid to its corporate shareholders. Indeed, the court noted, the rationale for the management fees appeared to be a last-minute scramble to list everything anyone remotely associated with either corporate shareholder did for Aspro. Neither Jackson Enterprises Corp. nor Manatt's Enterprises, Ltd., actually performed any of the "personal services" that Aspro argued justified payment of management fees. Neither corporate shareholder, the court observed, was in the business of providing management services or even was in a business related to that of Aspro's. Jackson Enterprises Corp. was a holding company, and Manatt's Enterprises, Ltd., was a farming business. Instead, the services were performed by individuals who worked for different entities.

In assessing whether Dakovich's management fees were reasonable in amount, the court considered a report by an IRS expert with experience in valuing compensation arrangements. The report noted that Dakovich's average annual salary and bonus was $460,323, which exceeded the industry average and median by a substantial margin. Considering only Dakovich's salary and bonus, the report concluded that Dakovich was overcompensated by approximately $215,000 annually during tax years 2012 through 2014. The court concluded that, because the management fees paid to Dakovich were ostensibly additional compensation for services that he performed as Aspro's president - services for which he was already highly compensated in comparison to peer companies - the entire amount of management fees paid to Dakovich appeared unreasonable.

The court also noted that there was no documentation explaining the fluctuation in management fees paid to each entity from $500,000 in tax year 2012 to $800,000 in tax years 2013 and 2014. Nor, the court said, did the fees paid to Dakovich represent payment for any particular service Dakovich provided. Instead, the board approved Dakovich's management fees as an additional reward beyond what he received through the employee bonus pool. Although the management fees were not exactly pro rata among the three shareholders, the two large shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests. This equal distribution supported an inference that Aspro paid management fees to Dakovich, Jackson Enterprises Corp., and Manatt's Enterprises, Ltd., as distributions of profits.

The fact that Aspro paid Jackson Enterprises Corp. and Manatt's Enterprises, Ltd., instead of the entities and individuals actually performing services, indicated to the court a lack of compensatory purpose. Another indication to the court that the management fees were disguised distributions to the shareholders was the fact that Aspro had relatively little taxable income after deducting the management fees. After paying the management fees, Aspro eliminated 89 percent, 86 percent, and 77 percent of what would have been Aspro's taxable income for tax years 2012 through 2014, respectively.

The court also looked at the independent investor test, which asks whether an inactive, independent investor would have been willing to pay the amount of disputed shareholder-employee compensation considering the particular facts of the case. The test is often used to assess whether the amount of shareholder compensation was reasonable in the light of the return on equity the corporation's shareholders received. Aspro never paid dividends to its shareholders and presented no evidence to the court showing that an independent investor would have been satisfied with investment returns after shareholder compensation.

The numerous indicia of disguised distributions showed the court that the management fees paid to the three shareholders were not in fact payments purely for services. Accordingly, the court held that the management fees were not deductible, even if Aspro could show the amounts were reasonable.

For a discussion of the tax treatment of excessive compensation and disguised dividends, see Parker Tax ¶44,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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