Tax Court rejects claimed deduction for management fees

BVWireIssue #222-3
March 17, 2021

federal taxation
management fees, shareholders, salary, distributions, deductible, disguised dividends, compensation paid, management services, provide a service, customary

The U.S. Tax Court recently agreed with the Internal Revenue Service that management fees a corporation paid to its three shareholders over a three-year period were not deductible since none of the fees were paid “purely for services” and the petitioner failed to show the fees were “ordinary, necessary, and reasonable.” Rather, they represented disguised distributions, the court found.

Disparate shareholders: The petitioner operated an asphalt paving business and had three shareholders. The company’s president owned 20% of the stock, an S corporation held 40%, and a C corporation also owned 40%. The court noted that the determination of the deductibility of the management fees was to be determined on an individual shareholder basis.

Under the applicable regulations, a corporation may deduct ordinary and necessary expenses, including salaries and other compensation, incurred during the tax year for the purpose of conducting a business or trade. Management fees are only deductible if they are payments “purely for services.”

The evidence suggested that the claimed fees were disguised distributions to shareholders, the Tax Court found, noting the company never made distributions to shareholders. Further, the management fees were evenly distributed closely to the shareholders’ interest in the company. Also, the company had little or no taxable income after the payment and deduction of the management fees.

The court also pointed out the petitioner failed to provide evidence, documentary or otherwise, for the cost or value of any particular service. No witness could explain how the fees were determined or what service they related to. Services were not even performed by the shareholder companies but by individuals from other entities. “Petitioner has to connect the dots between the services performed and the management fees it paid. Petitioner failed to do so,” the court said.

The court also examined the fees paid to the individual shareholder, i.e., the president of the company. It noted the individual shareholder is an employee of the company and provides services on an ongoing basis. However, the total compensation paid to him in his role as president must be reasonable. Here, the court said, the payments were not for any services beyond his responsibilities as president. The IRS, the court said, provided persuasive expert testimony that the executive was already overcompensated by his salary and bonus alone.

This case was a clear win for the IRS and an epic fail on the part of the petitioner, which presented its case poorly. It’s as if the petitioner over the years dared the IRS to catch it if it could, and the IRS did.

A digest of Aspro, Inc. v. Comm’r, TC Memo 2021-8 (Jan. 21, 2021) , and the court’s opinion will be available soon at BVLaw.

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