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Reclassifying Wages as Dividends by IRS Upheld by Tax Court

Reclassifying Wages as Dividends by IRS Upheld by Tax Court

The Tax Court has held in Aspro, Inc., TC Memo 2021-8 that payments made to a corporate taxpayer's three shareholders were dividends, not compensation for personal services rendered to the taxpayer, because the taxpayer had never previously paid dividends to the shareholders; the payments were roughly made in proportion to each shareholder's ownership; payments were made to two shareholders that were corporations, but the ostensible personal services were performed by individuals who owned those corporations; and the payments were made annually, but the personal services were performed throughout the year.

A corporation may deduct all the ordinary and necessary expenses paid or incurred during the tax year in carrying on any trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered. (Code Sec. 162(a)(1)Reg §1.162-7(a))

But the test of deductibility in the case of compensation payments is whether they are in fact payments purely for services. (Reg §1.162-7(a))

Aspro, Inc, the taxpayer, operated an asphalt paving business. Most of the taxpayer's revenue came from contracts with government entities. These public projects are awarded to the low bidder.

The taxpayer had three shareholders. Shareholder A, an individual, owned 20% of taxpayer. Shareholders B and C, both corporations, owned 40% each.

Shareholder A also was taxpayer's president and was responsible for the company's day-to-day management. His responsibilities included bidding on projects.

A often spoke to the individuals who owned B and C to get their advice on bidding for projects.

In 2014, taxpayer paid management fees to A, B, and C for their services in advising taxpayer on how to bid for projects. Taxpayer deducted these management fees as personal services rendered to taxpayer.

Neither in 2014 nor in any prior year did the taxpayer pay dividends to its shareholders.

The IRS denied the deduction, claiming the fees were actually dividends.

The Tax Court Ruled That The Payments Were Dividends,
And Not Personal Service Management Fees.

While the Court did not dispute that potentially a portion of payments made to A might have been compensation for personal services, since the payments were not purely compensation (as discussed below) the payments were not deductible under Reg §1.162-7(a).

The Court looked at various facts that it said were indicia that the payments were dividends. For example:

·         The taxpayer never made any dividend distributions to its shareholders during its entire corporate history. The taxpayer merely paid management fees. This lack of dividend payments indicates that the management fee payments lacked a compensatory purpose, the Court said looking at Reg §1.162-7(b)(1) (the taxpayer being a corporation with few shareholders).

·         Although the management fees were not exactly pro rata among the three shareholders, the two large shareholders always got equal amounts, and the percentages of management fees all three shareholders received roughly corresponded to their respective ownership interests. This distribution supported an inference that taxpayer paid management fees to the shareholders as dividends.

·         The fact that taxpayer paid shareholders B and C, instead of the individuals actually performing services, indicated a lack of compensatory purpose.

·         Taxpayer paid management fees as lump sums at the end of the tax year, rather than throughout the year as the services were performed.

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Read more at: Tax Times blog

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