August 4, 2021

Court Case on Treatment of Payments to Shareholders Resolved in Favor of IRS

By Heather Brady-Ginley, CPA, Senior Manager, Tax & Business Services

Court Case on Treatment of Payments to Shareholders Resolved in Favor of IRS Tax & Business

In early 2021, the Tax Court ruled on Aspro, Inc., a case involving the treatment of management fees paid to shareholders of a C-corporation. The Court agreed with the IRS that these payments were akin to dividend distributions and not deductible as management fees for all years audited.

The case involved a C-corporation that had three shareholders – one individual (the president of the entity) and two corporate shareholders. The payments made over the three years audited exceeded $4.7 million and were paid annually, at the end of each year. The entity operated as an asphalt paving business, and most of the revenue was from government contracts. The entity provided testimony that the management fees were paid for services from the shareholders related to their experience with government contracts and primarily included phone calls among the three shareholders. The two corporate shareholders were not in the asphalt business but did have experience with government entities and bidding on government jobs.

The Court reviewed the evidence and testimony provided by both parties and determined that the payments had more characteristics of a distribution and were not deductible. The Court noted that the entity had not made any dividend distributions to the shareholders since inception and that the timing of the payments, at the end of the year, did not appear to correlate with paying for recurring management services throughout the year. The entity also admitted that there was no contract with the shareholders regarding the services provided, the amount or frequency of payment, and no terms were discussed with the Board of Directors of the entity. The IRS also presented evidence that the experience, knowledge, and background of the employees of the corporate shareholders was not sufficient to establish a need for the payments to those shareholders.

Further, the IRS argued that amount of the management fee paid to the individual shareholder should be addressed when looking at total compensation to that shareholder as president of the entity. The IRS provided an expert witness who had analyzed all aspects of the compensation, bonus and management fees paid to the president shareholder and compared the total to other employees serving in similar roles at similar companies. The expert testified that the amount paid in salary and bonus alone exceeded reasonable compensation, so the IRS argued that the additional management fee should not be deductible as an ordinary and necessary business expense. In its decision, the Court also noted that the amounts paid as management fees did not seem to correlate to the services provided by each shareholder, and the amounts paid were closer to their ownership percentage; thus the Court deemed these more like dividend distributions than payments for services.

This case is a great reminder of the importance of documentation and support for any management fee arrangement utilized by an entity. The case also demonstrates the primary factors to consider in designing management fee agreements that can withstand IRS scrutiny.

Contact your Marcum tax professional for assistance in reviewing your management fee agreements and any other income tax matters.