Avoid IRS Red Flags in Multiple Business Strategies: A Guide for the Wary Tax Business Owner

Dear Savvy Strategists,

In the labyrinth of tax planning and business structure, the path to protecting your client’s multiple business strategy from the ever-watchful eye of the IRS can be as intricate as a well-played game of chess. However, while the strategic moves might be complex, the rules of the game are quite clear. Today, let’s dissect these rules with a blend of cautionary tales and cheeky wisdom, ensuring your business maneuvers stay sharp and IRS-compliant.

Ever heard of the tax strategy to just “create a new C corporation” and shift income by paying management fees from your main company?  Well, so has the IRS, and they are highly skeptical when they see it in the field.  The Aspro, Inc. v. Commissioner case serves as a stark reminder for taxpayers about the importance of meticulous documentation and the strict adherence to IRS guidelines for deducting management fees. Aspro, an Iowa-based C corporation in the asphalt-paving business, faced scrutiny over its practice of paying “management fees” to its shareholders, which the IRS and subsequent court rulings reclassified as non-deductible disguised dividends.

The Case of the Missing Details: A Cautionary Tale from Aspro Inc.

In the recent case of Aspro Inc. v. Commissioner (2021), we see a classic example of how not to play the game. Aspro Inc., a $23 million company, paid “management fees” to corporations owned by its shareholders, aiming to cleverly reduce its taxable income. Sounds smart, right? Wrong. The IRS wasn’t amused, especially since Aspro Inc. failed to provide a written management agreement, proper invoicing, or any semblance of a reasonable method to determine these fees. In short, they missed nearly every rule in the IRS’s playbook.

Often, there is as much to gain from reading opposing court judgements. The rulings serve as a blueprint for what “not to do.”

From 2012 to 2014, Aspro paid substantial management fees to its shareholders—two corporations and one individual who also served as the president of the company. Despite the company’s profitability over these years, no dividends were issued. Instead, the management fees were aligned with the shareholders’ ownership interests and were paid in lump sums at the end of each year. These payments effectively eliminated Aspro’s taxable income, drawing IRS attention.

The Golden Rule: Document, Document, Document

One of the first rules in protecting your clients’ multi-corporation strategy is the art of documentation. The IRS loves a good paper trail, and so should you. Every transaction between related parties must be backed by a written contract that not only exists but is followed religiously. It should detail the nature of services, the basis for pricing (ah, the mystical “arm’s length” standard), and be ratified in the corporate minutes. Remember, if it’s not written down, in the eyes of the IRS, it might as well not have happened.

Arm’s Length Pricing: The Magic Wand of Compliance

Setting prices between related entities can sometimes feel like choosing a wand in Ollivanders’ shop—complicated, and yet, it must choose you (or rather, it must be justifiable). Pricing should be comparable to what would be charged in a deal with an unrelated third party. The IRS scrutinizes these transactions intensely; a misstep here can turn your strategic tax planning into an expensive lesson in compliance.

Crucially, Aspro lacked structured processes for setting these fees and provided no substantial documentation such as written management service agreements, cost analysis of the services, or related invoices. This lack of evidence failed to satisfy both the Payment for Services Requirement—proving the fees were for actual services rendered—and the Reasonableness Requirement, which assesses the appropriateness of the fee amount.

During the proceedings, Aspro presented two expert witnesses in an attempt to validate the fees, but the court discounted their testimonies as they were deemed to lack scientific basis, relying instead on personal opinions. The Eighth Circuit supported this exclusion of testimony and the initial findings.

In determining the reasonableness of the fees, the court applied both an independent investor standard and a multi-factor standard, considering aspects like the nature of the work performed and prevailing compensation rates for similar services in the industry. Under these rigorous evaluations, Aspro’s management fees were judged to exceed reasonable compensation levels for the services claimed to be provided.

Invoicing: Your Fiscal Fairy Tale’s Gingerbread Crumbs

Invoices are the breadcrumbs that lead back to the legitimacy of transactions between related entities. Each service provided must be invoiced promptly and paid accordingly—no lump sums thrown at year-end to magically zero out corporate income, as was unfortunately the case with Aspro. These should be your narrative of compliance, clear and consecutive.

Aspro lacked structured processes and documentation for setting these management fees. There was no evidence of written management service agreements, cost analysis of the services, or invoices for the supposed management services provided. This absence of formal documentation and the timing and manner of the payments raised red flags that eventually drew IRS scrutiny.

Reasonableness: The Glass Slipper of Deductions

Just because a payment can be justified doesn’t mean it’s reasonable. Aspro’s management fees, which conveniently zeroed out income, failed the reasonableness test. Each fee and payment must fit your business as perfectly as a glass slipper: necessary, ordinary, and helping your business run smoother.

The Experts’ Role: Your Fairy Godparent

Sometimes, even the best-laid plans need a touch of magic—or expert testimony. In complex arrangements, having an expert can make the difference between a deduction held up in court and one that falls like a house of cards. Don’t be like Aspro, who went into battle without an expert, while the IRS had one.

Surviving an IRS Scrutiny: More Than Just Luck

When facing IRS scrutiny, luck favors the prepared. Aspro learned the hard way that unprepared defenses crumble. If you’re claiming deductions for management fees, be ready with all the documentation, from contracts to invoices and even third-party comparisons, to prove these were no fairy tale deductions.

In a similar case about management fees involving a dentist who created a management company, the IRS found the management fees paid were a sham and disallowed them.  The first issue is whether petitioner’s payments for purported management fees in 2005 and 2006 are deductible under section 162. The court found that they are not. Second, they had to decide whether business losses the Elick’s claimed for 2004, 2005 and 2006 (years at issue) are subject to the passive loss limitation under section 469. The court found these losses were passive and should have been suspended and not deducted.^[1]

In Wiley M. Elick DDS, Inc. v. Commissioner, Dr. Elick was the only employee of his management company and practiced dentistry full time for the C corporation to the S corp dental practice under a contract during 2005 and 2006. His spouse continued to work full time for the dental practice and performed many functions that the management company was to provide. Third parties performed payroll services and compliance training during 2005 and 2006.^[2]

The dental practice paid management fees of $430,000 for 2005 and $303,000 for 2006 to the C corporation. These amounts equaled 9.76% of the dental business’ annual gross receipts for 2005 and 9.98% for 2006. The management company never issued monthly invoices. Dr. Elick determined the amount of management fees paid, which were paid at the fiscal year’s end.^[3]

Keep in mind the taxpayer bears the burden of proving that the IRS determination of the deficiencies set forth in a deficiency notice is incorrect.^[4]

A Page from Dr. Elick’s Misadventures: Follow the Script

Dr. Elick’s attempt to manage his dental practice through a related corporation ended not with applause but with legal penalties and tax deficiencies. Despite having a written agreement, failure to demonstrate actual services and adhere to invoicing terms was his downfall. Take this as a script on what not to do: if your strategy includes a management agreement, following it to the letter is non-negotiable.

Parting Words: Play by the IRS’s Rules

Navigating the maze of IRS rules requires not just strategic acumen but a meticulous adherence to compliance. Whether it’s maintaining crystal-clear documentation, ensuring arm’s length transactions, or wielding expert opinions wisely, remember that in the great chess game of tax planning, every move counts. 

In my opinion, every sound tax plan should include a plan of documentation to go with it. Taking it a step further would also require clients to work with you monthly to ensure they are in compliance. Tax pros would agree that even well-intentioned small business owners are unlikely to complete proper compliance and documentation left to their own devices. Even surgeons performing serious operations require monitored recovery to ensure compliance with their instructions. Let’s take a page from their book and put our clients’ tax plans on life support!  

A Few Details About the Aspro Case For Inquiring Minds

The Court did not rule that management fees paid to a related party shareholder is not deductible, but did rule on the underlying factors to analyze if a deductible fee is paid to a related party, versus a non- deductible dividend.

Aspro could not explain how the management fees were determined and negotiated.

Aspro’s president conceded that he was performing only services as Aspro’s president and could not explain what his company did to earn management fees.

The court determined that the payments were not ordinary and necessary and were also not reasonable pursuant to IRC § 162(a)(1) and Treas. Reg. § 1.162-7(a).

Aspro did bring in an expert witness to justify payments made to its shareholder corporations or the reasonableness of these costs and fees. However, the IRS did utilize an expert to claim that such payments were not reasonable, ordinary, or necessary.

Aspro was sufficiently large that compliance costs did not significantly contribute to its failure in managing a related party transaction effectively. However, size alone is not the determining factor in such scenarios.