Unreasonable Compensation As Constructive Dividend, Redux

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An often-explored theme of this blog is the frequency with which similarly situated owners of similarly situated closely held business, facing a similar set of economic circumstances, and presented with a similar set of choices, will repeat the mistakes made by countless taxpayers before them.[i]

Rational behavior? Does the answer depend upon the taxpayer’s appetite for risk-taking? Being an entrepreneur necessarily involves some exposure to risk. However, there is a difference between the calculated risk that an intelligent business owner knowingly takes, on the one hand, and the risk that comes with negligently disregarding well-established tax principles, on the other.

Among the more common examples of such misbehavior by taxpayers are the following: “indebtedness” that is not intended to be satisfied,” below-market exchanges between related parties, questionable losses arising from dealings among related parties, weakly-supported valuations of transferred business interests or property, misclassified service providers, and a variety of sham transactions.

Thankfully, the foregoing situations – and the resulting adverse tax consequences – should be among the most easily avoidable because they generally fail to comport with economic reality; as such, they are readily identifiable by the taxpayer and their advisers.

Moreover, they typically do not involve especially convoluted fact patterns or complex issues of law where the outcome may be debatable and where a taxpayer may have a reasonable basis for its position.

Unfortunately, taxpayers continue to inadvertently flatter one another by imitating[ii] or repeating the mistakes of other taxpayers – mistakes that are readily identifiable by the IRS.

A recent case illustrates two more examples of taxpayer “misbehavior” that are often closely related to one another: unreasonable compensation and constructive dividends.[iii]

“Fees for Services”

Taxpayer was treated as a C corporation for federal income tax purposes. During the years in question, it had approximately 70 employees. Taxpayer’s outstanding shares of stock were held by: Individual (20 percent), who served as its president and as a member of its board of directors; Corp A (40 percent), an S corporation that acted as a holding company, which had no employees and no operations; and Corp B (40 percent), a C corporation that was not engaged in Taxpayer’s business.

Taxpayer did not declare or distribute dividends to its shareholders during the years in issue or in any prior years.[iv] However, at the end of every year,[v] Taxpayer paid each of its shareholders a “management fee” in a lump sum.

In addition to receiving management fees (set annually by Taxpayer’s board of directors), Individual received a salary, director fees, and bonuses (paid out of an employee bonus pool based on Taxpayer’s profitability) for each of the relevant years.[vi]

The management fee paid to Corp A was always equal in amount to the management fee paid to Corp B.[vii]

There were no written agreements between Taxpayer and its three shareholders regarding fees paid for management services, nor was there an employment contract between Taxpayer and Individual.

Tax Court Disagrees

Taxpayer claimed deductions on its tax returns for management fees for the relevant years.

The IRS denied these deductions on the ground that Taxpayer failed to establish that it had incurred or paid the management fees for ordinary and necessary business purposes. Taxpayer petitioned the U.S. Tax Court.

The Tax Court[viii] sustained the IRS’s decision denying the claimed deductions, finding that the fees were not paid as compensation for services but were instead disguised distributions of corporate earnings.

Taxpayer appealed to the U.S. Court of Appeals,[ix] challenging the Tax Court’s holding that none of the management fees paid by Taxpayer were deductible because they were instead disguised distributions of profits.

Court of Appeals

According to the Court,[x] whether payments made to shareholders are distributions of profits rather than compensation for services is a factual determination.[xi]

The Court explained that deductions are allowed for expenses that are “ordinary and necessary” in carrying on a trade or business, including “reasonable allowance for salaries or other compensation for personal services actually rendered.[xii]

“Ordinary,” the Court continued, “has the connotation of normal, usual, or customary” expenses within a particular trade or business, and also describes expenses arising from transactions “of common or frequent occurrence in the type of business involved.”  An expense was “necessary,” it stated, if it was “appropriate and helpful to the development of the business.”

Whether an expense is ordinary and necessary is generally a question of fact.

Compensation for Services

Having set forth the requirements for claiming a business deduction, the Court next turned to the treatment of compensation, generally. A deduction may be claimed for management services, the Court stated, if the payments are for services actually rendered and are reasonable in amount.

The Court added that, “Usually, courts only need to examine” the reasonableness of the amount paid. In general, reasonable compensation is limited to “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.”[xiii]

However, it continued, “the inquiry into reasonableness is a broad one and will, in effect, subsume the inquiry into” whether the payment includes a disguised dividend.

Because corporations are allowed to deduct amounts paid as reasonable compensation, but “are not allowed a deduction for dividends paid to the shareholders,” including distributions that are disguised as compensation, “compensation paid by the corporation to shareholders is closely scrutinized to make sure the payments are not disguised distributions.”[xiv] This is especially the case with closely held corporations, where there is often a lack of arm’s length negotiations.

The Court began its analysis by examining the payments made to Corp A and Corp B.

The Management Fees

Even though Taxpayer argued that at least a portion of the management fees it paid were reasonable, the Court concluded that Taxpayer failed to meet its burden to show that any of the management fees paid to Corp A and to Corp B were reasonable.

Taxpayer did not present evidence showing what “like enterprises under like circumstances” would ordinarily pay for like management services. It also did not quantify the value of the management services allegedly provided, nor did it show that similar companies would pay that amount for similar services.

Taxpayer produced no written management-services agreement or other documentation of a service relationship between Taxpayer and either entity, no proof of the services claimed to have been rendered, no evidence of how Taxpayer determined the amount of the management fees, and no evidence that either entity billed Taxpayer or sent invoices for any services performed for Taxpayer.[xv]

Further, the Court found that the management fees paid by Taxpayer to Corp A and Corp B were not purely for services rendered and were instead disguised distributions of profits.

No Distributions

In support of its finding, it pointed to Taxpayer’s history of never having made dividend distributions notwithstanding it enjoyed profits out of which dividends could have been paid.[xvi]

In contrast, Taxpayer paid management fees to its shareholders every year that were roughly proportional to the ownership interests of the shareholders.

For example, each of Corp A and Corp B owned forty percent of Taxpayer’s stock, and each received approximately the same percentage of the total management fees paid during the years in question; indeed, Corp A and Corp B always received equal amounts despite the different and varying services each was supposed to have provided to Taxpayer during each of the years at issue.

According to the Court, the fact that the percentage of management fees paid to the shareholders roughly corresponded to their respective ownership interests indicated disguised distributions of profits rather than compensation for services.[xvii]

Eliminate Profit

The Court found that Taxpayer had a “process of setting management fees [that] was unstructured and had little if any relation to the services performed”; however, at the end of each year, Taxpayer “had relatively little taxable income after deducting the management fees.”

In other words, the fees were set annually by Taxpayer’s board of directors so as to leave Taxpayer with a consistently negligible taxable income – a position that was supported by the fact the management fees were paid as lump sums at the end of the tax year, even though many of the services that Taxpayer claimed justified the management fees were performed throughout the year.

Individual’s Compensation

The court next turned to whether the management fees paid to Individual were deductible. This required a finding that the fees were reasonable and were in fact paid purely for services.

Again, the Court agreed with the findings of the Tax Court that Taxpayer failed to meet its burden to show that the management fees paid to Individual “would ordinarily be paid for like services by like enterprises under like circumstances.” Taxpayer did not present evidence showing what similar companies under like circumstances would pay as management fees (over and above salary and bonuses) to an employee like Individual for the same type of management services. It also did not quantify the value of the management services claimed to have been provided, nor did it show that like enterprises would pay that amount for such services.

In fact, the IRS’s expert opined that Individual’s salary and bonus alone exceeded the industry average and median by a substantial margin; thus, the payment of the management fees in addition to the salary and bonus could not have been reasonable for the services rendered.[xviii] What’s more, when the IRS’s expert added Individual’s excess compensation per year to their management fees, Individual’s share the fees over the years at issue approximated Individual’s 20 percent ownership interest in Taxpayer.

Reasonableness

To determine whether compensation paid to a shareholder-employee is reasonable, courts consider various factors, no single one of which is dispositive; rather, the court is to base its decision on a careful consideration of the applicable factors in light of the relevant facts and context as a whole. Among these factors are “the absence of profits distributed to the shareholders as dividends”; “the nature, extent and scope of the employee’s work”; and “the prevailing rates of compensation for comparable positions in comparable concerns.”

The Court reviewed each of these factors in turn:

  1. The failure to pay any dividends to shareholders in decades while regularly paying management fees justified “an inference that . . . the purported compensation really represents a distribution of profits.”
  2. Taxpayer’s explanation as to the “nature, extent and scope” of Individual’s work for which the management fees were “earned” were vague, as opposed to the work Individual performed to earn his salary and bonus.
  3. Individual’s compensation exceeded the prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry.

Notwithstanding that Individual had decades of experience, wide-ranging management duties, and long hours worked, in light of the countervailing factors, the Court concluded that the Tax Court did not clearly err in finding that Taxpayer had not met its burden of showing that management fees paid to Individual were reasonable.

The Court also sustained the lower court’s finding that the payments made to Individual were a disguised distribution and not purely for services. Taxpayer paid the management fees as lump sums at the end of the tax year even though the purported services were performed throughout the year, had an unstructured process of setting the management fees that did not relate to the services performed, and had a relatively small amount of taxable income after deducting the management fees.

Parting Thoughts

On the basis of the foregoing findings, it was not difficult for the Court to determine that the management fees paid to Individual, Corp A, and Corp B were not deductible – Taxpayer failed to carry its burden of showing that the fees were reasonable and were paid for services actually performed.

Which makes me wonder what Taxpayer was thinking when it began and then continued what eventually became its long well-established practice of paying management fees to its shareholders instead of distributing dividends? Taxpayer’s advisers must have appreciated that this method of withdrawing value from the corporation was suspect from a tax perspective.

Or did Taxpayer and its shareholders really believe that the profits realized by the business before accounting for the “pre-shareholder-management fee” were attributable to the services performed by the three shareholders, and that the approximately 70 employees working in the business (together with the equipment they used) did not generate a “return on investment”?

Or were Taxpayer’s shareholders hoping to ride the wave as long as they could?[xix]

Assuming Taxpayer’s position was “genuine” in the minds of its shareholders, how did they think it would be defensible or sustainable in an audit given the absence of any contemporaneous or other documentation relating to the nature, extent, and value of the services rendered?

Finally, can it be that the structure used did not represent an irrational tax decision but, rather, a compromise that sought to reconcile the tax status of the Taxpayer, Corp A, Corp B – a C corporation, an S corporation, and a C corporation, respectively – and Individual, while attempting to eliminate the entity-level tax for the operating business (i.e., Taxpayer)?

Although Taxpayer could not deduct a dividend paid to Corp B, the latter may have been able to deduct 65 percent of the dividend distribution from its gross income;[xx] Corp A (an S corporation) would not have enjoyed that benefit, though its shareholder(s) could have been taxed on such dividend at the favorable federal rate of 20 percent.[xxi] Or was Corp A concerned about having too much passive investment income?[xxii]

Did the owners think about moving Taxpayer’s business into an LLC treated as a tax partnership?[xxiii]

Lots of questions, the answers to which are irrelevant to Taxpayer at this point. The time for considering alternatives and then properly implementing them is well before establishing a course of conduct.

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.


[i] No, this is not going to be a discussion on rational choice theory, with which Adam Smith is credited, and according to which individuals presented with options will choose the one that best serves their self-interest.

However, I am channeling that great Sicilian, Vizzini, from The Princess Bride: “You fell victim to one of the classic blunders – the most famous of which is ‘never get involved in a land war in Asia’ – but only slightly less well-known is this: ‘Never go in against a Sicilian when death is on the line’! Ha ha ha ha ha ha ha!”

[ii] It is said that “Imitation is the sincerest form of flattery.” I suppose so, to a point.

[iii] For another discussion of constructive dividends, please see https://www.taxslaw.com/2022/03/constructive-dividends-and-the-closely-held-c-corporation/.

[iv] A period of over 40 years.

[v] For a period of 20 years.

[vi] The salary, director’s fees, and bonuses were not at issue.

[vii] You can’t make this up.

[viii] Aspro Inc. v. Comm’r, T.C.M. 2021-8.

[ix] IRC Sec. 7482; Tax Court Rule 190.

[x] Aspro, Inc., v. Comm’r, No. 21-1996 (C.A. 8th Cir.).

[xi] The Court stated that it would review the Tax Court’s factual determinations for clear error and “must affirm unless left with a conviction that the tax court has committed a mistake.”  All the facts and circumstances would be considered, the Court stated, “when determining whether the compensation paid to a corporation’s shareholders is actually a distribution of profits.” Taxpayer bore the burden of proving its entitlement to the deductions. Tax Court Rule 142(a)(1).

[xii] IRC Sec. 162.

[xiii] Reg. Sec. 1.162-7(b)(3).

[xiv] “Any payment arrangement between a corporation and a shareholder . . . is always subject to close scrutiny for income tax purposes, so that deduction will not be made, as purported salary, rental, or the like, of that which is in the realities of the situation as actual distribution of profits.”

[xv] Although closely held companies often act informally, with decisions not being documented in writing, taxpayers claiming deductions should keep records “sufficient to establish” whether they are entitled to a deduction. Reg. Sec. 1.6001-1(a); IRC Sec. 6001.

[xvi] “The absence of dividends to shareholders out of available profits justifies an inference that some of the purported compensation really represented a distribution of profits as dividends.”

[xvii] Reg. Sec. 1.162-7(b)(1) states that a disguised distribution is likely where “excessive payments correspond or bear a close relationship” to ownership interests.

[xviii] In fact, Individual was unable to explain what he did to earn the management fees.

[xix] I.e., before the IRS caught them; turned out to be a relatively long time.

[xx] IRC Sec. 243(c).

[xxi] IRC Sec. 1(h)(11); plus the 3.8 percent surtax on net investment income under IRC Sec. 1411.

[xxii] IRC Sec. 1362(d)(3), Sec. 1375.

[xxiii] Perhaps through an F reorganization. IRC Sec. 368(a)(1)(F).

No entity-level tax for the partnership, though there is phantom income (in the absence of distributions), and the members are treated as being engaged in the business of the partnership.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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