Tax Court holds improperly documented management fees not deductible

INSIGHT ARTICLE  | 

Authored by RSM US LLP


The Tax Court recently held in Aspro, Inc. v. Commissioner[1] that a corporation, which was closely held by three shareholders, could not deduct management fees paid to its shareholders because the payments were in fact distributions instead of compensation expenses paid purely for services rendered and reasonable in amount. While the management fees at issue in Aspro are distinguishable from management fees paid by private equity (PE) portfolio companies to management companies, which typically hold a small indirect investment in the portfolio company, the case serves as a warning to properly support and document management fees.

In general, compensation payments from a corporation to its shareholders are closely scrutinized to ensure they are not disguised distributions to shareholders subject to treatment under section 301.[2] Further, taxpayers bear the burden of proving entitlement to any deductions claimed,[3] and the Code and Regulations require taxpayers to maintain records sufficient to establish the amount of any deduction claimed.[4]

Under section 162, all ordinary and necessary business expenses paid or incurred by a corporation, including salaries or other compensation for personal services rendered, are deductible.[5] More specifically, compensation payments are deductible if the payments are both purely for services and reasonable under the circumstances.[6] Whether or not payments are purely for services is a facts and circumstances test.[7] Reasonableness is determined by comparing the payment to the amount that would be paid for similar services by a similar business under similar circumstances.[8]

In Aspro, the petitioner was a C corporation with an asphalt paving business. The petitioner had three shareholders, an individual owning 20% of the stock and two corporations each owning 40% of the stock. During the tax years at issue, the petitioner did not declare any dividends or make any distributions to the shareholders, but paid management fees to each shareholder at the end of every tax year.

The Tax Court first considered whether the management fees were “purely for services,” as required by Reg. section 1.162-7(a). The Court noted the absence of any distributions made to the shareholders[9] and that the amount of the management fees would significantly reduce the petitioner’s taxable income if permitted as a deduction.[10] The management fees were paid in amounts that approximately corresponded to each shareholder’s ownership interests in petitioner, suggesting the payments were distributions with respect to each shareholders’ stock.[11] In general, portfolio company management fees paid to fund management companies are distinguishable from the scenario in Aspro, as such fees are usually an annual fee based on a set percent of the total committed capital instead of an amount relative to the management’s ownership in the fund.

In addition, the Court concluded that petitioner’s process of setting management fees was unstructured and had little if any relation to the services performed. The fees were not set in advance of the services provided, and no explanation was given as to how the petitioner determined the amount of the fees. Other factors relevant to the Court’s conclusion were (i) the management fees were not paid throughout the tax year as the services were provided, but instead as a single lump sum at the end of the tax year; and (ii) in the case of the two corporate shareholders, the payments were made to the shareholders and not the entities and individuals that purportedly performed the services.[12] As a result, the Tax Court held that the management fees were not payments purely for services; therefore, they were not deductible.

The Tax Court also considered whether the amount of the management fees was reasonable. Concerning the two corporate shareholders, no documents or written agreements existed regarding the services to be performed, and the shareholders never sent invoices to petitioner for services rendered. Further, the petitioner neither provided evidence of what a similarly situated business would pay for the services nor explained the cost of each particular service or how it determined the fees.

As the individual shareholder was also an employee of the petitioner-corporation (i.e., its president), the Court separately addressed whether the management fees were reasonable when added to the individual’s existing compensation. The Court considered a number of factors relevant to determining whether the amount paid to a shareholder-employee is reasonable. Of significance is the Court’s conclusion that (i) the individual was overcompensated after taking into account the management fees; and (ii) while the petitioner’s operating margins were strong before taking into account the management fees, its margins were weak after including such fees as expenses.

As a result, the Tax Court concluded that the management fees paid to each of the two corporate shareholders and the individual shareholder were not reasonable; therefore, they were not deductible.

Aspro reinforces that management fees paid to shareholders are closely scrutinized to determine if the payments are more properly characterized as distributions with respect to stock instead of being deductible ordinary and necessary business expenses. Taxpayers bear the burden of maintaining records that demonstrate compensation payments are both reasonable and purely for services rendered. Aspro serves as a reminder that taxpayers seeking to deduct compensation payments must appropriately document and value such payments.

[1] T.C. Memo 2021-8.

[2]See Charles Schneider & Co., v. Comm’r, 500 F.2d 148, 152 (8th Cir. 1974); Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d 193, 194 (8th Cir. 1952).

[3] See INDOPCO, Inc. v. Comm’r, 503 U.S. 79, 84 (1992).

[4] Section 6001; Reg. section 1.6001-1(a).

[5] Section 162(a)(1); Reg. section 1.162-7(a).

[6] Reg. sections 1.162-7(a), (b)(1), and (b)(3).

[7] Am. Sav. Bank. v. Comm’r, 56 T.C. 828 (1971).

[8] Reg. section 1.162-7(b)(3).

[9] Citing to Paul E. Kummer Realty Co. v. Comm’r, 511 F.2d 313, 315 (8th Cir. 1975); Nor-Cal Adjusters v. Comm’r, 503 F.2d 359, 362-363 (9th Cir. 1974); Charles Scheider & Co., supra, note 2.

[10] Citing to Owensby & Kritikos, Inc. v. Comm’r, 819 F.2d 1215, 1325-1326 (5th Cir. 1987); Nor-Cal Adjusters, supra note 9; Wycoff v. Comm’r, T.C. Memo 2017-203.

[11] Citing to Reg. section 1.167-2(b)(1); Paul E. Kummer Realty Co., supra, note 9.

[12] Citing to Nor-Cal Adjusters, supra note 9.