On January 21, 2021, the Tax Court issued a Memorandum Opinion in the case of Aspro Inc. v. Commissioner (T.C. Memo. 2021-8). The sole issue presented in Aspro Inc. v. Commissioner was whether the petitioner was entitled to deductions for management fees paid to three shareholders.
Background to Aspro Inc. v. Commissioner
I find the petitioner suspect. First off, it is an Iowa C corporation, but it is not involved with the production or processing of corn. Strike one, Aspro. Second, the fine founders of the company actually chose the name “As[s]pro.” Apparently, there are no marketing interns in Iowa who used to be a 12 year old boy, who might have seen the flaw in this nomenclature. Strike two, As[hats].
Instead of making corn flakes or good decisions, the petitioner operated two stationary asphalt plants in Iowa and was limited to projects in the surrounding counties. Most of petitioner’s revenue came from contracts with government entities. These public projects are awarded to the low bidder. The petitioner had three shareholders, two 40% shareholders (entities) and one 20% shareholder (an individual).
The individual shareholder, Milton, was also the petitioner’s president and was responsible for the company’s day to day management. Milton did not, technically, have a “written” employment contract and did not, actually, receive “written” appraisals or performance reviews from the board of directors. Neither did Milton keep any records of hours worked but allegedly regularly worked 12-hour days. Milton’s base salary typically increased each year to take into account cost of living changes. His bonuses were paid out of an employee bonus pool that was based on petitioner’s profitability. His management fees were set by petitioner’s board of directors each year. Additionally, he received director’s fees for his service on the board.
AHA! One of the shareholders was “involved in farming operations in Iowa.” See, I told you that there would be corn involved here. It was inevitable.
The petitioner 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 petitioner at the beginning of any of the years in issue. And none of the shareholders invoiced or billed the petitioner for any services provided. Instead, the petitioner’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 minutes do not reflect how these determinations were made.
For that matter, with respect to two shareholders the board didn’t even attempt to value or quantify any of the services performed, but instead it approved a lump sum management fee for each shareholder for each year. The amounts were not determined after considering the services performed or their values. Neither did the fees represent payment for any particular service Milton provided. Instead, the board approved Milton’s management fees as an additional reward beyond what he received through the employee bonus pool.
The IRS, whose administrative corn allergy showed through in this case, completely disallowed the claimed management fee deductions and allowance of any IRC § 199 (domestic manufacturing) deductions.
Deductions under IRC § 162
A C corporation, such as petitioner, is subject to Federal income tax on its taxable income, which is its gross income less allowable deductions. IRC § 11(a); IRC § 61(a)(1); IRC § 61(a)(2); IRC § 63(a). A corporation may deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. IRC § 162(a)(1); Treas. Reg. § 1.162-7(a). An expense is ordinary if it is customary or usual within a particular trade, business, or industry or relates to a transaction “of common or frequent occurrence in the type of business involved.” Deputy v. du Pont, 308 U.S. 488, 495 (1940).
An expense is necessary if it is appropriate and helpful for the development of the business. See Commissioner v. Heininger, 320 U.S. 467, 471 (1943). Whether an expense is ordinary and necessary is generally a question of fact. Id. at 475. In testing whether compensation is deductible we consider whether the payments “are in fact payments purely for services.” Treas. Reg. § 1.162-7(a). This is a question of fact to be determined from all the facts and circumstances. Am. Sav. Bank v. Commissioner, 56 T.C. 828 (1971).
Courts closely scrutinize compensation paid by a corporation to its shareholders to ensure the payments are not disguised distributions. Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 152 (8th Cir. 1974); aff’g T.C. Memo. 1973-130. Indeed, courts have noted that where the corporation is controlled by the very employees to whom the compensation is paid, special scrutiny must be given to such salaries, for there is a lack of arm’s length bargaining. See also Heil Beauty Supplies, Inc. v. Commissioner, 199 F.2d 193, 194 (8th Cir. 1952).
Not Payments for Services Rendered
The petitioner has not shown that the management fees were paid “purely for services.” See Treas. Reg. § 1.162-7(a). To the contrary, most of the evidence indicates that petitioner paid the management fees to its three shareholders as disguised distributions. Treas. Reg. § 1.162-7(b)(1). The petitioner made no distributions to its three shareholders but paid management fees each year. No evidence indicates that petitioner ever made distributions to its shareholders during its entire corporate history. This indicates a lack of compensatory purpose. See Paul E. Kummer Realty Co. v. Commissioner, 511 F.2d 313, 315 (8th Cir. 1975) (noting the 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.”), aff’g T.C. Memo. 1974-44; Nor-Cal Adjusters v. Commissioner, 503 F.2d 359, 362-63 (9th Cir. 1974) (same), aff’g T.C. Memo. 1971-200. Perhaps most important in finding purported shareholder compensation represented disguised distributions is the fact that no dividends were ever paid by any of these companies during the years in issue, even though they enjoyed consistent profits and immense success in the industry. Charles Schneider & Co., 500 F.2d at 153.
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 correspond to their respective ownership interests. This equal distribution supports an inference that petitioner paid “management fees” as distributions of profits. See Treas. Reg. § 1.162-7(b)(1); see also Paul E. Kummer Realty Co., 511 F.2d at 316 (stating that the fact that amounts received by shareholders were “almost identical” to the percentage of stock held by each shareholder was indicative of disguised distributions).
Lump Sum Payments
Courts have found that a taxpayer’s payments of compensation to shareholders in lump sums rather than as services were performed was an indication that payments were disguised distributions. See Nor-Cal Adjusters, 503 F.2d at 362-63. Still others have concluded that a taxpayer’s payment scheme was indicative of a disguised distribution of profit where the shareholder was paid in one lump sum each year as opposed to throughout the year as services were rendered. Heil Beauty, 199 F.2d at 195.
Little Resulting Taxable Income
Another indication that the management fees were disguised distributions to the shareholders is the fact that petitioner had relatively little taxable income after deducting the management fees. Considering compensation as a percentage of taxable income before deducting the compensation in question is an accurate gauge of whether a corporation is disguising distributions of dividends as compensation. See Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1325-26 (5th Cir. 1987), aff’g T.C. Memo. 1985-287. The fact that a taxpayer consistently had negligible taxable income was an indication that compensation paid to shareholders was disguised distributions. Nor-Cal Adjusters, 503 F.2d at 362-63; Wycoff, T.C. Memo. 2017-203, at *46-*49 (same).
With respect to the two corporate shareholders, there were no written management services agreements outlining what services were to be performed. No evidence–documentary or otherwise–outlines the cost or value of any particular service. Neither corporate shareholder billed or sent invoices for services rendered. See ASAT, Inc. v. Commissioner, 108 T.C. 147, 174-175 (1997) (holding that the taxpayer was not entitled to deduct consulting fees where there was no written contract, no evidence regarding how the fees were determined, almost no detail in the billing invoices, and indications that the parties were not dealing at arm’s length). The Tax Court has previously held that a taxpayer was not entitled to deduct management fees paid to an affiliate when there was no written management services contract or other contemporaneous documentation, and the invoices had no details as to the services provided or the derivation of the invoiced amounts. Fuhrman v. Commissioner, T.C. Memo. 2011-236, *2-*3.
Reasonable compensation is only the amount that would ordinarily be paid for like services by like enterprises under like circumstances. Treas. Reg. § 1.162-7(b)(3). Neither corporate shareholder actually performed any of the “personal services” that petitioner argues justify payment of management fees. See IRC § 162(a)(1) (providing for a deduction for compensation paid for “personal services” actually rendered). Neither corporate shareholder was in the business of providing management services or even was in a business related to that of the petitioner.
The Tax Court has held that management fees paid to an affiliate are only necessary and reasonable–and therefore, deductible–if the affiliate provided the management services. See Elick v. Commissioner, T.C. Memo. 2013-139, *11-*12 (holding that the taxpayer was not entitled to deduct management fees paid to affiliate when the taxpayer failed to show that management services outlined in management services agreement were actually performed by the affiliate), aff’d, 638 F. App’x 609 (9th Cir. 2016). Indeed, management fees paid to an affiliate were not deductible when the evidence did not adequately establish the services performed and who performed them. Weekend Warrior Trailers, Inc. v. Commissioner, T.C. Memo. 2011-105, *19-*21.
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