Would Management Fees by Any Other Name Still Be Deductible?

Abstract

Although most deductions taken by taxpayers are uncontroversial and routinely permitted, some kinds of payments are categorically not deductible. Dividends, as a distribution of after-tax profits to corporate shareholders, are the traditional example. Depending on the differential in tax rates in play, it can be tempting to try to recharacterize payments that would otherwise be regarded as dividends as something else that would be deductible, such as interest payments (as compensation for the use of borrowed capital) or fees for services rendered (as reasonable compensation for work that was done independently of one’s status as a shareholder). Indeed, in many cases it is plausible that a shareholder has performed bona fide valuable services for a corporation. In these circumstances, the corporation may seek to deduct for tax purposes “management fees” that might in different circumstances be treated as dividends. If not backed up by economic substance, these recharacterizations of dividends as payment for services can lead to trouble. Tax authorities are rightly skeptical of claims that a payment is for services rather than dividends, particularly when there is a clear tax motivation on the part of the parties for doing so. In this article, we examine an appeal to the Eighth Circuit from the Tax Court’s January 21, 2021 decision in Aspro. We use machine-learning models to evaluate the strength of the appellant’s arguments in its appeal to the Eighth Circuit concerning the deductibility of management fees the business paid to its shareholders. We focus on the question of whether the payments to the corporate shareholders are likely to be considered ordinary and necessary expenses. In analyzing hundreds of previously decided cases and making a prediction, Blue J predicts with 74 percent confidence that the expenses will be treated as ordinary and necessary. Of course, 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 must still establish that the amounts it seeks to deduct in connection with these services are reasonable (an issue that might need to be redetermined by the Tax Court).