The U.S. Tax Court recently ruled that payments made to a corporate taxpayer’s three shareholders were dividends — not compensation for personal services rendered. The court’s reasoning also may be relevant in shareholder disputes and divorce cases when the parties disagree about whether compensation should be deducted from earnings when valuing a business interest. (Aspro, Inc. v. Commissioner, T.C. Memo 2021-8, Jan. 21, 2021.)
Under current tax law, a corporation may deduct all ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services rendered. In the case of compensation payments, a test of deductibility is whether they’re in fact payments purely for services.
On the other hand, distributions to shareholders disguised as compensation aren’t deductible for federal income tax purposes. Specifically, Internal Revenue Code Section 162 says:
Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.
The taxpayer operated as an asphalt paving business. Most of its revenue came from contracts with government entities. These public projects are awarded to the low bidder.
Aspro has three owners:
- Shareholder A is an individual who owned 20% of the company,
- Shareholder B is a corporation that owned 40% of the company, and
- Shareholder C is a corporation that owned 40% of the company.
Shareholder A also served as the company’s president and was responsible for its day-to-day management. His responsibilities included bidding on projects. Shareholder A often spoke to the individuals who owned corporate shareholders B and C to get their advice on bidding for projects.
In 2014, Aspro paid management fees to its shareholders for their advisory services on how to bid for projects. Aspro then deducted these management fees for personal services rendered. Neither in 2014 nor in any prior year did Aspro pay dividends to its shareholders. The IRS denied the deduction, claiming the fees were actually dividends.
Tax Court Decision
The Tax Court agreed with the IRS. It didn’t dispute that a portion of payments made to Shareholder A potentially might have been compensation for personal services. However, since the payments weren’t purely compensation, they weren’t deductible for federal income tax purposes.
Factors underlying the court’s decision to classify the payments as dividends, not a form of compensation, include:
Lack of historical dividend payments. Aspro is a corporation with few shareholders that never distributed any dividends during its entire corporate history; it merely paid management fees.
Payments corresponding to ownership percentages. The management fees weren’t exactly pro rata among the three shareholders. However, the two corporate shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests.
Payments to shareholders, not individuals. Aspro paid the amounts to corporate shareholders B and C, instead of to the individuals who actually performed the advisory services.
Timing. Aspro paid management fees as lump sums at year end, rather than paying them throughout the year as the services were performed.
A taxpayer can deduct compensation payments as a business expense for federal income tax purposes only if the payments are reasonable in amount and paid purely for services rendered. However, reasonableness is in the eye of the beholder.
Examples of factors that courts consider when analyzing reasonable compensation include:
Role in the company. This factor includes the individual’s position, duties performed and hours worked.
External comparisons. It’s important to compare the individual’s compensation to what similar companies pay unrelated parties for performing similar services.
Character and condition of the company. Courts sometimes evaluate the company’s size (as measured by revenue, net income or capital value), complexities of the business and general economic conditions. More challenging work generally warrants a higher level of compensation.
Internal consistency of compensation. Most companies follow a structured, formal and consistently applied program when paying workers. Subjective or erratic bonus payments or payments that violate company policy may be suspect.
Potential conflicts of interest. Relationships between the company and an employee may provide an opportunity for the company to disguise nondeductible corporate dividend distributions as deductible compensation. Such a relationship may exist when an employee is the company’s controlling shareholder or a member of the controlling shareholder’s family.
A business valuation expert or tax advisor can help you estimate how much compensation is reasonable, as well as adjust corporate earnings as needed. These decisions will be based on the facts of the situation and objective, market-based evidence that will withstand scrutiny.
The appropriate treatment of payments to shareholders should be decided on a case-by-case basis. The decision has implications beyond federal income taxes. To the extent that a company’s value is based on its earnings or net free cash flow — say, under the income or market approaches — the deductibility of these payments can have a major impact on the value of a business interest.
The federal income tax rules for how to treat these expenses can provide objective guidance when classifying payments for other purposes. In some cases, it may be appropriate to adjust a company’s earnings for deductions that represent dividends, based on the facts of the case. Contact us for more information.