Eighth Circuit Affirms Tax Court; Payments to Shareholders Were Disguised Dividends

(Parker Tax Publishing May 2022)

The Eighth Circuit affirmed the Tax Court and 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 found that the company failed to establish that the payments were reasonable; the court further found that the payments were not purely for services, considering that the company did not pay dividends and the fees were typically paid at the end of the tax year even though they were purportedly for services rendered throughout the year. Aspro, Inc. v. Comm'r, 2022 PTC 110 (8th Cir. 2022).

Background

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 years at issue, Aspro's stock was held by: 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), who also served as the president of Aspro.

Aspro has not paid dividends since the 1970s. However, except for one year, Aspro has paid its shareholders "management fees" for at least 20 years. In addition to receiving management fees, Dakovich received a salary, director fees, and bonuses for each of the years at issue. 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. The IRS denied these deductions on the ground that the management fees were not ordinary and necessary business expenses under Code Sec. 162(a). In T.C. Memo. 2021-8, the Tax Court sustained the IRS's decision denying Aspro's claimed deductions on the ground that the fees were not paid as compensation for services, but instead were disguised distributions of corporate earnings. In reaching its decision, the Tax Court excluded the testimony of Aspro's expert witnesses, who opined as to the value of services Aspro received in return for the management fees. Aspro appealed to the Eighth Circuit.

Under Code Sec. 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. Under David E. Watson, P.C. v. U.S., 2012 PTC 33 (8th Cir. 2012), and Reg. Sec. 1.162 - 7(a)), a deduction for salaries is allowed if the salary is both (1) reasonable and (2) in fact payments purely for services. Reg. Sec. 1.162-7(b)(1) provides that deductions for compensation will be disallowed if a purported salary or other similar payment is in reality a distribution of profits by the corporation. Reg. Sec. 1.162-7(b)(3) generally limits "reasonable compensation" to the amount that would ordinarily be paid for like services by like enterprises under like circumstances. In Charles Schneider & Co. v. Comm'r, 500 F.2d 148 (8th Cir. 1974), the Eighth Circuit applied a multi-factor test to determine whether the amount of compensation paid to an employee is reasonable. These factors include (1) whether profits were distributed to shareholders as dividends, (2) the nature, extent, and scope of the employee's work, and (3) the prevailing rates of compensation for comparable positions in comparable concerns.

Analysis

The Eighth Circuit affirmed the Tax Court's decision to deny Aspro's claimed deductions as well as the Tax Court's decision to exclude the testimony of Aspro's experts.

The Eight Circuit agreed with the Tax Court that Aspro failed to show that any of the management fees it paid to Jackson Enterprises Corp. and Manatt's Enterprises, Ltd., were reasonable. Aspro did not present evidence, in the court's view, showing what "like enterprises under like circumstances" would ordinarily pay for like management services and did not quantify the value of the management services provided. The court also noted, as the Tax Court did, that 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.

The court also agreed 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. The court noted that Aspro has made no dividend distributions since the 1970s but has paid management fees every year but one for 20 years. The court also found that Aspro's management fees were in amounts roughly proportional to the ownership interests of the stockholders. In the view of the Eighth Circuit, the Tax 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 did 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.

Regarding the management fees paid by Aspro to Dakovich, the Eighth Circuit found that Aspro failed to show that such fees would ordinarily be paid for like services by like enterprises under like circumstances. According to the Eighth Circuit, 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 court said, the value of the management services Dakovich provided, nor did it show that like enterprises would pay a similar amount. In fact, the court noted, the IRS's expert witness said the exact opposite - 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 Dakovich's excess compensation per year was added to his management fees, the court found, his share of the total management fees over the three years at issue was 22 percent, closely aligning with his 20 percent ownership interest in Aspro.

The court further found that the management fees paid to Dakovich were not reasonable under the Schneider multifactor analysis. The fact that Aspro has not paid any dividends to stockholders since the 1970s, the court said, justified an inference that Dakovich's compensation really represented a distribution of profits. The court added that, as with Jackson Enterprises Corp. and Manatt's Enterprises, Ltd., Aspro (1) paid Dakovich's management fees as lump sums at the end of the tax year even though the purported services were performed throughout the year, (2) had an unstructured process of setting the management fees that did not relate to the services performed, and (3) had a relatively small amount of taxable income after deducting the management fees. Thus, the Eighth Circuit concluded that Aspro failed to show that the fees were reasonable and purely for services actually performed.

The Eighth Circuit also upheld the Tax Court's exclusion of the testimony of Aspro's proffered expert witnesses: Gale Peterson, Jr., a contractor in the highway construction industry; and William Kenedy, a CPA who specializes in business valuation. The court found that Peterson's testimony as to the value of the various services at issue in the case would not be helpful in understanding the evidence because Peterson relied only on his personal experience working for Aspro and his knowledge of the shareholders in the industry. The court found that Kenedy did not articulate what principles and methods he used, if any, to conclude that "valuable services" were provided.

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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