IRS Hot Button: Deductible Management Fees vs. Disguised Distributions

The IRS may question the amount paid to shareholder-employees as tax-deductible salaries, bonuses and management fees. Excess amounts can be reclassified as distributions, which aren’t deductible for federal tax purposes.

When assessing what’s “reasonable,” the U.S. Tax Court considers multiple factors together with the independent investor test. A recent Tax Court case — Aspro, Inc. v. Commissioner — demonstrates this approach.

9 Factors

In Aspro, the Tax Court listed the following nine factors to consider when determining whether shareholder-employee compensation is reasonable:

1. The employee’s qualification,
2. The nature, extent and scope of the employee’s work,
3. The size and complexities of the business,
4. Comparisons of salaries paid with the company’s gross and net income,
5. Prevailing general economic conditions,
6. A comparison of salaries with distributions to stockholders,
7. The prevailing compensation rates for comparable positions in comparable businesses,
8. The taxpayer’s salary policy for employees, and
9. For small corporations with a limited number of officers, the amount of compensation paid to the employee in previous years.

No single factor is determinative. Instead, the court considers these factors on a case-by-case basis.

The most significant factor that worked against the plaintiff in Aspro was the prevailing compensation rates for comparable positions. Additional factors that supported the IRS position included the company’s lack of historical dividend payments; payments to shareholders that roughly corresponded with ownership percentages; and payments made to corporate shareholders, not individuals. In addition, management fees were paid as year-end lump sums — such compensation is generally paid throughout the year as the services are performed.

Independent Investor Test

The Tax Court supplemented its multifactor approach with the independent investor test. This test asks: Does the company’s shareholder-employee compensation level allow for adequate returns for hypothetical independent investors?

In Aspro, the taxpayer didn’t present evidence or expert witness testimony on this issue. But analyses performed by the IRS’s expert concluded that the taxpayer’s operating income margins after paying management fees were significantly below those of its industry peers. Low profitability generally correlates with low investor returns.

The court agreed. It ruled that, after paying management fees to its three shareholder-employees, the business wouldn’t have sufficient operating income left for hypothetical investors. Therefore, the management fees paid to the company’s shareholder-employees over three years weren’t deductible for federal income tax purposes; instead, they represented disguised dividends.

Beyond Tax

Reasonable compensation can also be an issue outside of a federal income tax context. For example, it may play a role in shareholder disputes and divorce cases. An independent financial expert can provide objective evidence and detailed analyses to corroborate (or refute) the reasonableness of shareholder-employee compensation.