Benjamin Alarie (Osler Chair in Business Law, University of Toronto; CEO, Blue J Legal) & Christopher Yan (Senior Legal Research Associate, Blue J Legal), Disguised Distributions and Management Fees: Aspro Revisited, 175 Tax Notes Fed. 1401 (May 30, 2022):
In this article, Alarie and Yan analyze the Eighth Circuit’s recent decision in Aspro concerning the deductibility of management fees the business paid to its shareholders.
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. 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 appeal and on April 26 the Eighth Circuit released its opinion, upholding the Tax Court’s decision. 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. 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. ...
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.
Prior TaxProf Blog coverage:
- Blue J Predicts: An Unprofitable Pretax Venture Can Still Be A Partnership (June 29, 2021)
- Blue J Predicts With 68% Confidence That IRS's Economic Substance Challenge Will Fail In District Court Perrigo Case (Aug. 6, 2021)
- Blue J Predicts With 77% Confidence That Reserve’s § 501(c)(15) Appeal Will Be Dismissed By The Tenth Circuit (Sept. 10, 2021)
- Blue J Predicted With 95% Confidence That 7th Circuit Would Affirm Tax Court In Innocent Spouse Cases (Oct. 5, 2021)
- Blue J Predicts With 74% Confidence That 8th Circuit Will Find Customary/Usual Management Fees Are Deductible Under § 162 (Nov. 3, 2021)
- Blue J Predicts: Taxpayers Face Uphill Battle In Assignment Of Income Cases (Dec. 8, 2021)
- Blue J Predicts: Worker Classification In The Gig Economy (Dec. 20, 2021)
- Blue J: Using Machine Learning To Crack The Tax Code (Feb. 8, 2022)
- Blue J Predicts With 86%-95% Confidence That 10th Circuit Will Find That Taxpayer In Olsen Was Not Engaged In A Trade Or Business (Feb. 28, 2022)
- Blue J Predicts With 65%-94% Confidence Federal Circuit's Step Transaction Decision In GSS Holdings (Apr. 5, 2022)
- Blue J Predicts With 86% Confidence Debt-Equity Decision In Tribune Media (May 4, 2022)