This is a guest post by Harold McClure, a New York City-based independent economist with 26 years of transfer pricing and valuation experience. (One of several that he has written for us.) Here he examines Aspro v. Commissioner. The case recently went before US Court of Appeals, which ruled in favour of the IRS. A key issue was the management fees paid to the shareholders, and the taxpayer had no documentation to back up its position.
On April 26, 2022 the U.S. Court of Appeals for the 8th Circuit ruled in favor of the IRS in Aspro v. Commissioner (No. 21-1996). This decision upheld a Tax Court decision that disallowed certain intercompany management fees arguing they were disguised dividends. Although the taxpayer argued that at least a portion of the fees were reasonably deductible business expenses, the courts ruled the taxpayer failed to demonstrate that the lion’s share of these expenses represented reasonable compensation for services provided.
Aspro is asphalt-paving business in Iowa. Aspro had three shareholders including Jackson Enterprises Corporation and Manatt’s Enterprises, Ltd., which each held 40 percent of the shares. Milton Dakovich held the remaining 20 percent of the shares and did work as Aspro’s president. During the period from 2012 to 2014, Aspro paid its shareholders management fees based on their shareholdings, which lead to recorded profits equal to zero. As such, no dividends were paid to these shareholders.
The courts criticized the taxpayer’s position on several grounds. Aspro produced no written management-services agreement or other documentation of a service relationship between Aspro and any service provider, no evidence of how Aspro determined the amount of the management fees, and no evidence that either entity billed Aspro or sent invoices for any services performed for Aspro.
The taxpayer presented an expert witness whose testimony was not convincing. Our focus will be on the testimony of the expert witness for the IRS – Ken Nunes. Aspro also paid Dakovich a salary, director fees, and bonuses in addition to the management fee. Nunes asserted that Dakovich’s salary and bonus exceeded the industry average and median by a substantial margin and that management fees in addition to the salary and bonus were not reasonable. The court decision noted:
“Aspro argues that Dakovich’s compensation should be calculated as an estimate of his annual hours multiplied by the Commissioner’s “concession” that Dakovich’s time was worth $200 per hour. However, Aspro’s argument misinterprets Nunes’s testimony. The $200-per-hour figure represents the market rate a company would have to pay a professional firm to purchase equivalent senior level services. It includes direct compensation and benefits for the executive; the overhead costs of the firm, such as its costs of recruiting temporary staff; and its profits. Because of this, the figure includes a fifty-eight percent markup from what Nunes considered reasonable compensation for a senior-level professional comparable to Dakovich. Nunes testified that if Aspro planned to hire a similar person directly as an employee, which Dakovich was, the compensation paid would be $128 per hour.”
Aspro is a privately held company and the court did not specify its financials. The following table relies on the limited publicly available information to provide an illustration of the issues by assuming that annual sales = $15 million while operating expenses excluding Dakovich’s compensation and the intercompany management services = $14 million. If Dakovich worked 2000 hours a year receiving total compensation = $200 an hour, then he received $400,000 in salary and management fees. If the arm’s length fee for his services was only $250,000 per year, then his excessive compensation would be $150,000 per year. Since the other two shareholders owned twice as much in shares each, we have assumed that each corporation received $300,000 per year in management fees. The combined salary and management fees would therefore be $1 million per year resulting in no recorded profits.
The IRS position on the other hand is that the salary of the president with no management fees should be deducted. Under this position, the profits of Aspro would be $750,000 per year or 5 percent of sales. Under the IRS position, the combined president salary and intercompany management fees would be 1.67 percent versus the taxpayer’s position that these fees should be 6.67 percent.
Aspro Financials Under Two Intercompany Management Fees
|Salary and management fee||$1000||$250|
The evidence presented by the IRS expert witness focused on what would be reasonable compensation for the services provided by its president. Two alternative comparisons may have proved useful if reliable financial data on companies with similar business as the Aspro asphalt-paving business could be obtained. One approach would be to inquire what is the typical percent of sales for management services for third party companies. The other approach might be to inquire what is the typical operating margin would be for comparable third party companies. Whether such an application of the Comparable Profits Method (CPM) would yield similar results would be an interesting inquiry.
Transfer pricing documentation is more than simply evaluating financial results. The taxpayer in this litigation was criticized for not having an intercompany agreement. Intercompany management fee agreements are often expressed in terms of fees as a percent of sales. While the section 1.482-9 regulations endorse the Comparable Uncontrolled Services Price approach, third party agreements provide little guidance as to whether the management fee should be above 6 percent of sales versus less than 2 percent of sales. If a formal agreement did specify that the intercompany management fee should be some fixed percentage of sales, the ex post financial results could be tested for reasonableness under an application of CPM. Our discussion hopefully provides some insights in this regard.
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