Taxes in Your Practice: Eighth Circuit affirms tax court finding of disguised distributions was not a rental property

Scott E. Vincent

Scott E. Vincent is the founding member of Vincent Law, LLC in Kansas City. 

Background

Aspro, Inc. is an asphalt-paving corporation organized under Iowa law and treated as a subchapter C corporation for federal tax purposes. During the years in question, Aspro was owned by three shareholders, including two business entities and Milton Dakovich, who was also the president of Aspro. 

Aspro had a history of paying its shareholders “management fees” almost every year, but Aspro had not paid dividends since the 1970s. During the years in question, Dakovich received salary, director fees, and bonuses, in addition to management fees. There were no written agreements between Aspro and its shareholders for management services, and Dakovich did not have a written employment contract with Aspro.

The IRS denied Aspro's deductions for management fees for the tax years 2012 through 2014, finding that the management fees were not ordinary and necessary business expenses under Code §162. The tax court sustained the IRS findings, determining that the management fees were not paid as compensation for services but were instead disguised distributions of corporate earnings.

Code § 162 allows deductions for expenses that are ordinary and necessary in carrying on a trade or business, including reasonable salaries and compensation for personal services. Regulations § 1.162-7(b)(1) provides that compensation deductions will be disallowed if a purported salary or similar payment is actually a profits distribution by the corporation. Regulations § 1.162-7(b)(3) limits “reasonable compensation” to an amount that would ordinarily be paid for like services by like enterprises under like circumstances. The Court confirmed this requires a factual determination, and notes that in prior cases the 8th Circuit Court has applied multiple factors to make reasonable compensation determinations, including whether profits were paid to the shareholders as dividends; the nature, extent, and scope of the employee’s work; and prevailing rates of compensation for similar positions in comparable concerns. 

Eighth Circuit Court analysis and decision

The 8th Circuit Court rejected Aspro’s arguments and affirmed the tax court’s holdings. The court first rejected Aspro’s claim that the tax court abused its discretion in excluding testimony by two of Aspro’s expert witnesses. The 8th Circuit Court did not find an abuse of discretion by the tax court in excluding testimony from the two experts, based on findings that one expert’s “report does not offer an opinion as to the value of the various services at issue in this case nor does he apply scientific principles and methods,”[3] and the other expert’s report did not “articulate what principles and methods he used, if any, to conclude that ‘valuable services’ were provided.”[4]

Next, Aspro challenged the tax court’s holding that none of the management fees paid by Aspro to its entity shareholders were deductible. The 8th Circuit Court found that the tax court did not clearly err in finding that Aspro failed to meet its burden that any portion of the management fees paid to its entity shareholders was reasonable. The Court of Appeals found that Aspro provided no evidence “showing what ‘like enterprises under like circumstances’ would ordinarily pay for like management services.”[5] The Court of Appeals recited the tax court findings that Aspro produced no written management-services agreement or documentation of a service relationship, no evidence of how management fee amounts were determined, and no evidence that either shareholder entity billed or invoiced Aspro for any services.[6] The 8th Circuit Court also emphasized Aspro’s history of paying management fees to shareholders without making any distributions of profits, further noting that Aspro paid management fees to its shareholders roughly in proportion to their ownership interests in the corporation.  Based on these findings, the 8th Circuit Court found that the tax court did not clearly err in concluding that all management fees paid to Aspro’s entity shareholders were nondeductible. Finally, the Court of Appeals addressed whether management fees paid to Dakovich were deductible as reasonable payments purely for services. As with the other shareholders, the 8th Circuit Court found that Aspro presented no evidence of what similar companies would pay as management fees (over and above salary and bonuses) in like circumstances, including Dakovich’s status as an employee. The court also relied on the IRS expert’s conclusion that Dakovich received salary and bonus substantially higher than the industry average and median, and that management fees in addition to this salary and bonus was not reasonable. The IRS expert also found that Dakovich’s combined excess compensation and management fees were closely aligned with his ownership interest in Aspro, as was the case with the entity shareholders.

Based on these findings of excess compensation, alignment of the management fees with ownership interests, and lack of any shareholder dividends, the 8th Circuit Court held that the tax court did not clearly err in finding that Aspro failed to meet its burden of showing that the management fees paid to Dakovich were reasonable. The court further concluded that payments to Dakovich were therefore disguised distributions and were not purely for services actually performed.

Conclusion

The 8th Circuit Court decision in Aspro demonstrates key lessons for taxpayers attempting to justify C corporation management fees to shareholders. Aspro did not have written management fee agreements, did not make any dividend distributions of profits, and was not able to show a reasonable market basis for the amounts paid as management fees. If these facts had been different, it seems likely the court would have allowed at least some management fee deductions for the corporation. Importantly, this case also demonstrates a potential area of audit interest by the IRS, which likely includes both C corporation management fees and compensation.

Endnotes 

[1] Scott E. Vincent is the founding member of Vincent Law, LLC, in Kansas City. 

[2] 32 F.4th 673 (8th Cir. 2022).

[3] Id. at 676.

[4] Id. at 677.

[5] Id. at 678.

[6] Id.