In some instances, C corporations prefer to designate payments as amounts for compensation, rather than payments of dividends. The IRS sees it another way, and the Courts backed it up.

As shown in a new case decided by a court of appeals, Aspro, Inc. v. CIR, No. 21-1996, CA-8, 4/26/22,  a C corporation can’t disguise dividends as compensation or some other form of deductible payment to its shareholders.

Background: In some instances, C corporations prefer to designate payments as amounts for compensation, rather than payments of dividends. The reason is simple: Compensation is deductible by the corporation while dividends are not.

But the corporation can’t just choose the approach that suits its purposes. Compensation must be paid for services rendered while dividends are attributable to the earnings and profits earned by the entity.

Frequently, the IRS uncovers dividends that have been designated as compensation during an audit. In this case, it may make adjustments to the corporation’s tax liability, establishing that the dividends were received constructively.

Note that employee shareholders are taxed individually on both compensation and dividends. However, unlike dividends, compensation is also subject to payroll taxes.

Facts of the new case: From 2012 through 2014, the asphalt paving business in Iowa operated as a C corporation. Most of the corporation’s revenue stemmed from contracts with government entities. The business had three shareholders. Two of them each owned 40% of the corporation and the other owned 20 percent.

The corporation paid management fees to each of the shareholders for the tax years in question. Although the management fees paid were not exactly pro-rata among the three shareholders, the two largest shareholders received equal amounts each year. The percentages of management fees for all three shareholders roughly corresponded to their respective ownership interests.

Notably, the corporation didn’t enter into any written management or consulting services agreements with any of the three shareholders. There was no management fee rate or billing structure agreed to by the parties at the beginning of the year. None of the shareholders invoiced or billed the corporation for services provided.

Instead, the board of directors would approve the management fees at a meeting late in the year. Finally, the corporation had no history of paying any dividends. 

The IRS contested deductions for management fees paid by the corporation to the three shareholders and made tax adjustments. The Tax Court agreed with the IRS.

Tax outcome: Now the Eighth Circuit Court has gone along with the initial ruling by the Tax Court. Based on all the facts and circumstances, the fees constitute disguised distributions of profit.

Among several critical factors, the Court noted that the corporation made the payments without valuing the services the owners provided, it had no dividend-paying history, and that the percentage of the fees received by each owner roughly corresponded to their respective ownership interests in the corporation. In fact, the corporation had little taxable income after deducting the fees. Case closed.