It is common for private equity and other closely held businesses to pay management fees to a shareholder or entity related to a shareholder. In general, the management fees are deductible, even if paid to a shareholder, so long as the fee is an ordinary and necessary expense, and the amount is reasonable. Two decisions by the courts, the initial disallowance and subsequent upholding of the disallowance, are a warning to taxpayers that proper documentation of management fees is important, particularly when paid to shareholders or related parties.
On April 26, 2022, the Eighth Circuit affirmed[1] the tax court’s decision[2] disallowing management fees claimed by the taxpayer. For a more detailed discussion of the tax court decision, see our article Tax Court holds improperly documented management fees not deductible. In affirming the Tax Court, the Eighth Circuit first took aim at the expert testimony the tax court excluded, holding that the tax court correctly excluded testimony that the taxpayer argued would support the value of the services provided. In one case, the court held the testimony lacked the “intellectual rigor” that an expert in a field would employ, and in the other, the court agreed that the testimony was “based upon personal belief rather than an expert analysis.” Taxpayers should take note of this and consider the advisors they look to in supporting their tax reporting positions.
Next, the court looked to the taxpayer argument that the Tax Court erred in disallowing all of the management fees. Noting that the question of whether a payment is compensation for services or a distribution by the corporation is a facts and circumstances analysis, the court focused on the question of whether the amounts were reasonable. In holding for the government, the court pointed to the taxpayer’s failure to meet the burden to establish reasonableness, by neither quantifying the value of the services nor providing any service agreement or proof of invoicing to the company for services. The court went further, agreeing with the Tax Court that the payments were a distribution of profits. Supporting their conclusion, the court noted that the company did not have any history of making distributions but had consistently paid management fees “roughly proportional” to stock ownership in the company, and the management fees were unstructured and consistently were utilized to result in negligible taxable income for the company.
In summary, as is often the case, the IRS is willing to attack and litigate a bad set of facts. Failure to document services or reasonableness of the fee, the use of the fees to create negligible income and the payment closely proportionate to ownership put the taxpayer in a difficult position defending the fee. This case is also a reminder for taxpayers to do their due diligence when engaging professionals to support their tax positions because the IRS and courts will not necessarily accept the testimony of a witness if it is not supported by the appropriate analysis. The case can serve as a blueprint of what not to do and provide a roadmap for taxpayers to properly document and sustain management fee deductions that they pay to shareholders or related entities.
[1] Aspro, Inc. v. Commissioner, No. 21-1996 (8th Cir. 2022).
[2] Aspro, Inc. v. Commissioner, TC Memo 2021-8.
