Disguised Distributions and Management Fees: Aspro Revisited

I. Introduction

In our Blue J Predicts column we use advances in machine learning to analyze pending or recently decided federal income tax cases. This month we follow up on the appeal of a Tax Court decision that we first examined in October 2021.¹ In Aspro, the taxpayer challenged the IRS’s determination that the “management fees” it paid were not deductible because they were disguised corporate distributions of profits. Our initial analysis focused on the pending appeal² and on April 26 the Eighth Circuit released its opinion, upholding the Tax Court’s decision.³ This is the first time a case we have examined in Blue J Predicts has been decided by an appellate court since we began the column in mid-2021.

So we now consider the Eighth Circuit’s concerns with Aspro’s management fee arrangements. Our examination suggests that there is a significant overlap between the factors that drive the ordinary and necessary analysis and the reasonable compensation analysis in determining the deductibility of business expenses. Our review demonstrates that the taxpayer would have benefited from considering all the factors identified by Blue J’s algorithm at the tax-planning stage.

Although we did not render a prediction in our previous Aspro column on the deductibility of the expenses in dispute, we did examine how machine learning could be used to assess the likelihood of whether the payments in question were ordinary and necessary expenses. Recall that a payment must not only be (1) ordinary and necessary to be deductible, but must also be (2) reasonable and purely for services (that is, the payment cannot be found to be a disguised distribution of profits). The Tax Court denied the deduction of all the management fee payments — holding that the payments made to corporate shareholders were not ordinary, necessary, and reasonable — while payments made to the individual shareholder satisfied the ordinary and necessary test, but were not reasonable.

We explained that if the Eighth Circuit did not deviate from the Tax Court’s findings that the payments were disguised distributions or unreasonable, then the ordinary and necessary analysis might be moot.⁴ We concluded that for services that were not customary or usual, Blue J’s algorithm predicted with 56 percent confidence that the services would not be considered ordinary and necessary. For services that the Tax Court declined to find were not customary or usual, Blue J’s algorithm predicted with 74 percent confidence that the expenses would be considered ordinary and necessary. It is worth reiterating that establishing that expenses are for services that are of an ordinary and necessary nature is not, by itself, sufficient to result in entitlement to a deduction; Aspro would still be required to establish that the amounts it seeks to deduct are reasonable and in fact purely payment for services. On appeal, this proved to be problematic for Aspro considering the significant sufficiency-of-evidence issues.

The Eighth Circuit affirmed the Tax Court’s denial of the management fees Aspro paid to its shareholders, finding no error in the lower court’s determination that Aspro failed to demonstrate that the management fees were reasonable and failed to present evidence showing what like enterprises under like circumstances would ordinarily pay for similar management services. But the appellate court did not engage in any significant substantive discussion on whether the expenses were ordinary and necessary and decided the issue on the narrower basis of the Tax Court’s finding that the taxpayer failed to establish the fees were reasonable and for services performed.

At first glance, the absence of any major discussion of the ordinary and necessary nature of the expenses would appear to render our original analysis using machine learning as moot. However, as we detail below, our analysis reveals that the taxpayer would have been in a much stronger position on both fronts by addressing the factors identified by Blue J’s algorithm at the tax-planning stage.

II. Background

Aspro involved a dispute over the deductibility of management fees the company (a C corporation engaged in the asphalt pavement business) paid to its three shareholders: two corporations, each with 40 percent ownership, and an individual with 20 percent ownership. The individual shareholder was an employee and the president of Aspro. He received compensation for his services, which included a salary, bonus and management fee. The corporate shareholders were also paid management fees for various services ostensibly performed by affiliates. Aspro deducted the management fees paid to each shareholder for 2012, 2013, and 2014, thereby reducing its taxable income in each of those years. The IRS denied the deductions. The taxpayer challenged the IRS. The Tax Court found in favor of the IRS.⁵

A. Recap of Tax Court Opinion

The Tax Court sustained the IRS’s denial of the deductions for management fees on the basis that the payments to the shareholders were disguised distributions of profits. The court found that the payments to the corporate shareholders were not ordinary, necessary, and reasonable, and that the payments to the individual shareholder, while ordinary and necessary, were not reasonable.

The Tax Court scrutinized many aspects of the management fee payment arrangement. In finding that the expenses were not deductible, the Tax Court highlighted the following:

• Aspro did not have a history of making distributions to its shareholders, and instead had always paid them in the form of management fees.

• The amount of the management fees, if deductible, would have eliminated most of Aspro’s taxable income (ranging from 77 percent to 89 percent in the relevant tax years).

• The management fees were paid in amounts that roughly corresponded to each shareholder’s ownership interest, suggesting that payments arose out of each shareholder’s equity in the business. Moreover, the corporate shareholders that had identical share ownership in Aspro were paid identical amounts in management fees for all the tax years in dispute.

• There was little to no evidence of any method being used to determine the amount of the management fees that were payable. The fees were not set in advance of the services that were performed.

• The management fees were not paid as the services were provided throughout the year but rather as a single lump sum at the end of the tax year.

• The purported services were performed by individuals and entities affiliated with the corporate shareholders while the payments were made directly to the corporate shareholders.

• There were no documents or written agreements regarding the services to be performed and no invoices were sent to Aspro for services rendered.

• There was no evidence of what similarly situated businesses would pay for the services, nor was there a breakdown of how each particular service corresponded with the fees that were paid.

• Evidence was lacking about whether the expenses were customary or usual in relation to the business.

As a result, the Tax Court found that the fees paid to the corporate shareholders were disguised distributions and concluded that they were not ordinary, necessary, and reasonable. On that basis, the Tax Court denied the entire deduction for management fees paid to Aspro’s shareholders.

B. Recap of Eighth Circuit Opinion

Aspro’s appeal was heard by Chief Judge Lavenski R. Smith and Judges Raymond W. Gruender and Jonathan A. Kobes. Gruender, writing for the court, affirmed the Tax Court’s denial of the claimed deductions and the granting of the IRS’s motion to exclude Aspro’s proffered expert witness testimony.

The first substantive part of the opinion concerned Aspro’s appeal of the Tax Court’s decision to exclude the testimony of Aspro’s two experts (a contractor in the highway construction industry and a CPA specializing in business valuation). Although significant to Aspro’s appeal, this portion of the case is not central to the remainder of our analysis (even though Aspro’s evidentiary issues, as discussed below, in part relate to its failure to establish that the services provided were valuable). In short, the Eighth Circuit held that the Tax Court did not abuse its discretion in excluding the testimony of Aspro’s experts.

1. Eighth Circuit’s reference to law.

The second substantive part of the Eighth Circuit’s opinion considered the deductibility of the management fees paid to shareholders by reciting the law that the payments must be (1) ordinary and necessary and (2) reasonable in quantum and purely for services.

The Eighth Circuit said that expenses must be ordinary and necessary in carrying on a trade or business to be deductible under section 162(a)(1). This includes “reasonable allowance for salaries or other compensation for personal services actually rendered.” The court also held that the word “ordinary” should have “the connotation of normal, usual, or customary,” and that “ordinary” describes expenses arising from transactions that are of “common or frequent occurrence in the type of business involved.” In the court’s view, the word “necessary” meanwhile “means appropriate and helpful to the development of the business.” This recitation is largely the extent to which the court addressed the legal meaning of “ordinary and necessary.”

The court then explained that for a salary to be deductible it must be both (1) reasonable and (2) payment purely for services. Reasonable compensation is limited to “such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” Moreover, the court emphasized that corporations may not deduct dividends paid to shareholders, including any payments that are more appropriately characterized as disguised distributions of profits rather than as compensation for services.

2. Eighth Circuit’s application of law.

In applying the law, the Eighth Circuit determined that the Tax Court did not err in concluding that the management fees were not deductible because Aspro failed to meet its burden to show the fees were reasonable and purely for services. The court’s analyses of the corporate shareholders and individual shareholder were conducted in separate sections of the opinion. When framed side by side, however, it is evident that the analyses are parallel.

Table 1 summarizes the factors considered by the Eighth Circuit and presents a side-by-side comparison of the corporate and individual shareholders, despite the fact that the Tax Court found that the payments to the individual shareholder were ordinary and necessary (although not reasonable in amount) while declining to find that payments to the corporate shareholders were ordinary and necessary.

Table 1. Summary of Eight Circuit’s Considerations in Finding That Aspro Failed to Demonstrate Fees Were Reasonable and Purely for Services

	Corporate Shareholders	Individual Shareholder
Evidence of whether similar enterprises incurred these expenses	Aspro did not present evidence showing what “like enterprises under like circumstances” would ordinarily pay for like management services.	Aspro did not present evidence showing what similar companies under like circumstances would pay as management fees (over and above salary and bonuses) for the same type of management services.
Evidence of the quantum of expenses incurred by similar enterprises	Aspro did not quantify the value of the management services provided, nor did it show what similar companies would pay for similar services.	Aspro did not quantify the value of the management services provided, nor did it show what like enterprises would pay for them.
IRS’s expert evidence (not an independent factor, but addresses the taxpayer’s objections on appeal)	Contrary to Aspro’s assertions, the IRS’s expert did not concede that the corporate shareholders provided valuable services, but rather, that the services had some value, without any analysis on whether services were factually provided.	The IRS’s expert concluded that the individual shareholder’s compensation exceeded the prevailing rates of compensation paid to those in similar positions in comparable companies within the same industry.
Failure to substantiate specifics of the work	Aspro produced no written management services agreement or other documentation of a service relationship between Aspro and either entity and no evidence of how Aspro determined the amount of the management fees, and there was no evidence that either entity billed Aspro or sent invoices for any services performed for Aspro.	Aspro’s explanation is vague as to the nature, extent and scope of the individual shareholder’s work for which he earned management fees, as opposed to the work he performed to earn his salary and bonus.
History of dividend distributions	Aspro made no dividend distributions since the 1970s and paid management fees every year but one for 20 years.	Aspro paid no dividends to stockholders since the 1970s and regularly paid management fees.
Payments proportional to ownership (disguised distribution)	Aspro paid management fees in amounts roughly proportional to the ownership interests of the stockholders.	The individual shareholder’s excess compensation aligned closely with his 20 percent ownership interest in Aspro.
Timing of payments	Management fees were paid as lump sums at the end of the tax year even though many of the services that Aspro claims justified the management fees were performed throughout the year.	Aspro paid the management fee as a lump sum 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 fee that did not relate to the services performed; and had a relatively small amount of taxable income after deducting the management fees.

As is evident above, the Eighth Circuit took issue with many of the same characteristics in relation to payments made to the corporate shareholders and the individual shareholder.

III. Analysis

As noted in our original machine-learning analysis, Blue J uses machine learning to model how the courts have approached the characterization of ordinary and necessary business expenses under section 162(a) in more than 500 previous decisions, dating back to 1933. The facts and circumstances used in Blue J’s predictions are the ones that judges refer to and place weight on in reaching their decisions. When considering whether an expense is ordinary and necessary Blue J’s algorithm takes into account 23 separate factors.

Of the six factors explicitly considered by the Eighth Circuit on whether the payments were reasonable and for services, four factors overlap with the algorithm’s consideration of whether a trade or business expense is ordinary and necessary. These four factors are bolded in Table 1. While the consideration of whether an expense is ordinary and necessary and whether an expense is reasonable are distinct concepts in law, the Tax Court applied both together in relation to the corporate shareholders, and the Eighth Circuit upheld the Tax Court’s reasonableness analysis.

A. Competitors Incurring Expense

In our earlier article, we split the consideration of whether there was any evidence that similar enterprises and competitors likely incurred this type of expense into two categories: (1) expenses that the court found that Aspro had failed to establish were customary or usual and (2) expenses that the court did not find that Aspro had failed to establish were customary or usual.

We then concluded that when holding all other factors constant, being able to establish that similar enterprises likely incurred this type of expense would assist the taxpayer with safely establishing that the expense was ordinary and necessary with 74 percent confidence. Failure to establish that competitors incurred this type of expense would put the taxpayer’s position in jeopardy, with the algorithm being 56 percent confident that the expense would not be considered to be ordinary and necessary. Table 2, considering this factor from our original article, has been reproduced below.

Table 2. Effect on Outcome of Whether Competitors Likely Incurred This Type of Expense

	Competitors Likely Incurred This Type of Expense	Ordinary and Necessary?
Scenario 1	Yesa	Yes, 74%
Scenario 2	Nob	No, 56%
aServices for which the Tax Court did not find that the taxpayer failed to establish that the service or expense was customary or usual. bServices for which the Tax Court found that the taxpayer failed to establish that the service or expense was customary or usual.

To consider the strength of the factors, our original analysis gave the generous interpretation that expenses that the Tax Court did not find that Aspro had failed to establish were customary or usual could be considered expenses that the Tax Court implicitly accepted were the type of expenses that other similar enterprises incurred (knowing that absence of evidence to the contrary does not equate to evidence of existence). Unfortunately, the Tax Court did not distinguish between these two types of expenses and applied a blanket finding that all expenses were not ordinary, necessary, and reasonable (and this blanket application of all expenses as being homogenous appears to have been reproduced in the Eighth Circuit’s decision).

In its decision the Eighth Circuit seemed to accept that the taxpayer failed to establish that any of the payments were expenses that similar enterprises would have incurred. Whether treating all expenses as homogenous is appropriate is a separate matter (and possibly lumped together for expediency on the part of the Eighth Circuit), but it is evident that failure to furnish evidence of this type of expense being incurred by similar enterprises jeopardizes the claim from the algorithm’s perspective of whether it is an ordinary and necessary expense as well as the consideration of whether that expense is reasonable.

B. Evidence of Quantum of Expenses

Our original analysis also considered whether there was a substantially more cost-effective way of achieving the same outcome, by examining whether the taxpayer was able to substantiate the cost of comparable services.

If the taxpayer was able to establish that the competitor likely incurred this type of expense, there was a 10 percent difference in the algorithm’s confidence if there was a substantially more cost-effective way of achieving the outcome (79 percent confident versus 69 percent confident the expense was ordinary and necessary); conversely, if the taxpayer was not able to establish that the competitor likely incurred this type of expense, there was a 22 percent difference in the algorithm’s confidence (from 60 percent confident the expense was ordinary and necessary versus 72 percent confident the expense was not ordinary and necessary). Table 3, considering this factor from our earlier article, is reproduced above.

Table 3. Cumulative Effect on Outcome of Changes to Multiple Factors

	Competitors Likely Incurred This Type of Expense	Substantially More Cost-Effective Way of Achieving Outcome	Ordinary and Necessary
Scenario 1	Yes	No	Yes, 79%
		Unknown	Yes, 74%
		Yes	Yes, 69%
Scenario 2	No	No	Yes, 60%
		Unknown	No, 56%
		Yes	No, 72%

We discussed how the taxpayer’s inability to confidently present evidence would have shifted the odds so that it is more likely than not to fail on the ordinary and necessary issue on this factor alone. Indeed, the Eighth Circuit concluded that Aspro could not quantify the value of the management services provided by the shareholders, nor could it quantify what similarly situated enterprises would pay for similar services. In fact, regarding the individual shareholder, the Eighth Circuit relied on the IRS expert’s conclusion that the individual shareholder’s compensation exceeded prevailing rates of compensation, suggesting there was evidence that there would have been a substantially more cost-effective way of obtaining similar services, further driving the ordinary and necessary analysis in favor of the IRS.

C. Payments to Shareholders

Payment to shareholders was not a factor that we considered in the machine-learning section of our earlier analysis, because the whole purpose of the arrangement was to advance payments to shareholders in a manner that allowed the corporation to take a deduction for payments in exchange for services rendered. But we discussed this factor in passing in our original analysis when we reported that in 22 of 43 rulings in which payment was made to a shareholder, some part of the expense was still found by courts to be ordinary and necessary.

Accordingly, this is not usually a decisive factor on its own. Our algorithm reveals that this factor affects its confidence by just 2 percent when the taxpayer is able to substantiate that competitors likely incurred this type of expense and affects the algorithm’s confidence by 5 percent when the taxpayer is unable to substantiate that its competitors likely incurred this type of expense. Although this table was not in our original analysis, we include it to illustrate its modest effect.

Table 4. Cumulative Effect on Outcome of Changes to Multiple Factors (Payment to Shareholders)

	Competitors Likely Incurred This Type of Expense	Expense Resulted in Payment or Benefit to the Shareholder	Ordinary and Necessary
Scenario 1	Yes	No	Yes, 76%
		Yes	Yes, 74%
Scenario 2	No	No	No, 51%
		Yes	No, 56%

It should be noted that while payments to shareholders do affect the ordinary and necessary analysis, whether these payments to shareholders are proportional to ownership is not specifically considered for the purposes of the ordinary and necessary analysis. Instead, the proportionality of the payments goes to the analysis of whether these payments were disguised distributions of profits (and therefore, not payment for services). Still, a robust ordinary and necessary analysis should include consideration of the fact that payments to shareholders are prone to be subject to scrutiny by the IRS and the courts.

D. Timing of Payments

Finally, the Eighth Circuit also considered the periodic timing of the payments and took issue with the fact that management fees were paid as lump sums in a way that did not correspond with when the services purportedly were performed. This factor was not discussed in our original analysis because the taxpayer, at the litigation stage, would no longer have been able to change the timing of the payments that were made to the shareholders. Our algorithm has also identified that the periodic nature of payments is a powerful factor. It can affect the algorithm’s confidence of whether an expense is ordinary and necessary by more than 20 percent.

However, similar to the consideration of whether payments were made to shareholders as a factor, for the purposes of the ordinary and necessary analysis, our algorithm does not engage in the more granular consideration of whether the timing of payments coincided with the services performed; rather, the algorithm only considers whether these payments were periodic expenses for the purposes of satisfying the ordinary component of an ordinary and necessary expense. Still, when contemplating this factor under a prospective ordinary and necessary analysis, a taxpayer should also consider whether the timing of the payments coincides with the characterization of the payments as payment for services.

IV. Conclusion

It is interesting to observe that even though the test for whether an expense is ordinary and necessary is, in theory, distinct from the test for whether an expense is reasonable and in fact a payment for services, there is significant overlap in the consideration of factors under both. Moreover, in Aspro, the Tax Court combined the analysis in relation to payments made to corporate shareholders while the Eighth Circuit focused primarily on whether the expenses were reasonable in quantum and appropriately regarded as payment for services. This suggests that in practice, courts may not always apply a strictly methodical approach in considering the legal tests distinctly, but instead may sometimes combine analyses in determining whether a payment was ordinary, necessary, and reasonable when rendering a ruling on the deductibility of an expense.

Because the Eighth Circuit did not rule on whether the expenses were ordinary and necessary and proceeded directly to considering whether the expenses were reasonable and payment for services, we cannot know whether any of the expenses would have been considered ordinary and necessary.

Ultimately, the taxpayer in Aspro failed because of a lack of evidence justifying the nature and quantum of expenses, a lack of contemporaneous documentation supporting the characterizations, and proper tax planning as far as the timing and quantum of payments were concerned. As noted in our original analysis, Aspro should continue to serve as a cautionary tale that taxpayers who seek to claim deductions must take special care to substantiate the form and labels they choose to characterize their transactions. It is a critical practice point to note that taxpayers are best served by developing contemporaneous documentation, even if (perhaps, especially if) they operate as closely held corporations. Here, Aspro’s lack of supporting documents gave the Eighth Circuit sufficient basis to challenge the reasonableness and to characterize the payments as disguised distributions of profits rather than to engage in the ordinary and necessary analysis it might have done had the taxpayer been more carefully prepared.

Taxpayers could certainly benefit from using legal technology to identify relevant practices and develop robust documentation at the tax planning stage to avoid scrutiny from tax authorities. The process of doing so would compel them to confront the myriad considerations necessary to successfully execute an arrangement such as the one in Aspro.