Change your Facts, Same Tax

Generally speaking, tax follows the facts. One can of course change those facts, but when done so merely superficially, intended results may not follow. Some may be more familiar with the phrase “putting lipstick on a pig.” Well, that seems to be more or less the case in the recent opinion released in the Eighth Circuit Court of Appeals.[1]

In many situations, planners can get all too busy by molding the square peg into the round hole, making all appropriate factual changes to a plan, transaction, relationship, or entity, whatever the case may be. While that is a great first step, one’s tax game is a lot like golf; you cannot neglect a solid follow-through. Specifically, one must make sure that these new facts exist in an environment supportive of these facts, that these facts are not just superficial, and that they reflect the economic and situational realities at play. One common area at issue is with C corporations.[2] A shareholder-employee can receive money in a multitude of ways. However, writing a check and calling it one thing does not make it what you call it. For example, a year-end payment cannot magically be a management fee instead of a dividend or bonus just because you called it that. Such was the case in Aspro Inc.

Facts

The taxpayer in Aspro Inc. was an asphalt paving company in Waterloo, Iowa taxed as a corporation under subchapter C. The relevant years at issue were 2012-2014.[3] For at least twenty years leading up to the dispute with the IRS, save for one year, the taxpayer paid its shareholders management fees and not dividends. One such shareholder was Milton Dakovich, president of the taxpayer (“Dakovich”). Dakovich was compensated a few different ways, including salary, director fees, and bonuses. Somehow, without any written agreement outlining a special and distinct relationship supportive of such a distinguishable relationship, the taxpayer paid Dakovich (and other shareholders) a management fee. To make things more difficult, there was no employment agreement.[4] At Tax Court, each side submitted expert witness testimony. The taxpayer’s expert testimony was excluded and the IRS won resulting in the denial of deductions for payment of management fees to the shareholders. As a result, the taxpayer’s management fees were reclassed as disguised distributions of corporate earnings.

Analysis[5]

The primary issue in the case was whether the Tax Court erred in excluding the testimony of the expert witness of the taxpayer and in turn whether the management fees were properly reclassed as non-deductible dividends. As to the expert witness, lacking documentation, and scientific methodology with respect to an expert’s analysis, instead pontificating based on personal beliefs is not expert analysis. As such, the Court struck the expert testimony. In short, it appears the taxpayer’s expert witness merely offered conclusive self-serving statements lacking any real analysis or supporting information.

With respect to the management fees, the Court had to determine whether the deemed management fee payments to the shareholders were distributions of profits rather than compensation for services based on factual determinations.[6] Absent a conviction that the Tax Court made a mistake with respect to a factual determination, the appellate court had to affirm.[7] Thus, the taxpayer was required to carry the burden of proof of proving its entitlement to deductions for the management fees paid.

This issue was important likely because in the years at issue, corporate tax rates were higher than they are now. Being a C corporation, the corporation would pay tax on its income at the higher corporate rates than the shareholders would pay on a dividend. As a result, a higher-income taxpayer could pay an appreciable amount more in income tax as a result. The shareholders could collectively take home more if the taxpayer paid less tax at the corporate level and passed through the income to the shareholders directly as management fees. Considering at least two shareholders were non-employees, management fees seemed the perfect vehicle for such an arrangement. While such a structure, where a shareholder can receive income via both salary and profit distribution, can be put in place with an S corporation, it is unlikely the taxpayer would qualify to be an S corporation given the fact two shareholders were entities as well, with one being a de facto corporation, Jackson Enterprises Corp.

Neither the Tax Court nor the Eighth Circuit bought the taxpayer’s position. With respect to the two entity-shareholders (non-employees), there were no contractual arrangements or any indication of a demonstrable relationship of services rendered to amount to the management fees paid. Instead, management fees seemed to fall suspiciously in line with proportional ownership.[8] These facts seemed telling to the Court that such payments were merely disguised dividends. The Court affirmed the Tax Court, holding that the payment of the management fees to the entity-shareholders were non-deductible.[9]

As to Dakovich, things were muddier. Because Dakovich was an employee as well as a shareholder, being a contractor too just made the analysis that much more complicated for the taxpayer. The situation with Dakovich with respect to any substantiation or evidence supporting the taxpayer’s position was similar to the entity-shareholders. While the taxpayer described some services rendered, there was a failure to show that the payments were reasonable and in fact payments purely for services. The government’s expert testified as to comparable compensation arrangements in a similar enterprise. Dakovich’s compensation already exceeded the median by a substantial margin and the combination of management fees with his existing salary and bonus were not reasonable in the eyes of the Court. When combining salary, bonus, and management fees, his share of the total amounts paid to shareholders was about twenty-one percent, approximately his ownership in the taxpayer.

In determining whether compensation paid to a shareholder-employee is reasonable, the Court looked to a multitude of factors noting that no single factor was dispositive. Particular factors were “absence of profits paid back to shareholders as dividends” “the nature, extent[,] and scope of the employee’s work” and “a most significant factor […] the prevailing rates of compensation for comparable positions in comparable concerns.”

Conclusion

There were no agreements, no counter expert testimony, no profit distributions, a telling relationship of fees to proportional ownership, and a lack of indication of any ties to value of services performed. Dakovich’s already high compensation arrangement as a shareholder-employee, and the year-end lump-sum payments of the management fees. The whole arrangement appeared great on paper but lacked significant substance. The tone of this case review is not to wave a finger uttering “shame shame shame” upon the taxpayer, but to remind taxpayers and advisors alike that follow-through is paramount. One can change their facts and in turn change the tax results. However, the changes to the facts must not be superficial and should reflect the economic and situational realities at play. The importance of this comes two-fold when layering separate taxpayers (i.e. utilizing a C corporation) as correlative adjustments are not always made, and a great idea can turn into a massive whipsaw if one is not careful.

Here, the taxpayers could have likely utilized a separate and distinct management company that would have operated as a true, separate, and distinct management company charged with handling the operations of the company. This structure occurs a lot and can serve as an administrative salvation or nightmare, depending on how it is utilized. Just forming a management company and running profits through it as a “management fee” will likely not garner the respect that a true separately operated management company would. When stepping away and looking at this case empirically, it is pretty easy to see that what appears to have happened is that the taxpayer decided to distribute funds out as a management fee and what effectively was a dividend was changed merely in name only.

[1] Aspro Inc. v. Comm’r, 129 AFTR 2d 2022-XXXX (8th Cir. 2021)

[2] See Blossom Day Care Centers, Joshua W. Sage (Aug. 3, 2021), Corporation Liable for Employment Tax on Reasonable Compensation, Charles J. Allen (July 28, 2021), and Deductibility of Son-in-Law’s Tuition Expense, Gray Edmondson (May 9, 2022).

[3] Were the years at issue 2018 or later, it is likely dividends would have been preferred given the drop in C corporation tax rates and the total effective rate upon the shareholders at issue.

[4] An employment agreement is not required for an employment arrangement, but it would have certainly served helpful to distinguish roles to which different types of compensatory arrangements would relate.

[5] This discussion is less focused on the evidentiary rules at play and more on the substance of the issues presented.

[6] See Heil Beauty Supplies, Inc. v. Comm’r, 199 F.2d 193, 194-95 (8th Cir. 1952).

[7] See Keating v. Comm’r, 544 F.3d 900, 903 (8th Cir. 2008).

[8] See Treas. Reg. § 1.162-7(b)(1).

[9] It is uncertain to the author at this time whether a correlative adjustment would exist to true-up the tax effect of this ruling. Based on other cases, it is likely the Court would not be bound to make such adjustments and any “whipsaw” effect would likely be the result of operating with multiple taxpayers.