Company Says Tax Court Erred in Denying Management Fee Deductions
DATED JUL. 16, 2021
Aspro Inc. v. Commissioner
COMMISSIONER OF INTERNAL REVENUE,
IN THE UNITED STATES COURT OF APPEALS
FOR THE EIGHTH CIRCUIT
On Appeal From The United States Tax Court
Case No. 8:19-cv-45
Hon. Cary Douglas Pugh, United States Tax Court Judge
BRIEF OF APPELLANT, ASPRO, INC.
Prepared and Submitted by:
Brian J. Brislen
Adam R. Feeney
LAMSON DUGAN & MURRAY LLP
10306 Regency Parkway Drive
Omaha, NE 68114
Tel: (402) 397-7300
Fax: (402) 397-7824
ATTORNEYS FOR APPELLANT
SUMMARY OF CASE AND REQUEST FOR ORAL ARGUMENT
Appellant Aspro, Inc. (“Aspro”) is a successful asphalt paving company based in Waterloo, Iowa. At issue are the management fees Aspro paid to its three shareholders — Milt Dakovich; Jackson Enterprises, Corp. (“Jackson Enterprises”); and Manatt's Enterprises, Ltd. (“Manatt's Enterprises”) in 2012, 2013, and 2014. The Commissioner denied all deductions Aspro took for the management fees paid for these years. The Commissioner's expert conceded that Aspro's shareholders provided at least some valuable services to justify a portion of the management fee deduction, after a bench trial, the Tax Court affirmed the Commissioner's denial.
In affirming the denial of all of Aspro's management fee deductions, the Tax Court committed multiple legal and factual errors. This Circuit has not adopted the Tax Court's position that, regardless of whether the amount was reasonable, all management fees were non-deducible because Aspro lacked compensatory intent in paying management fees. Instead, the weight of authority is that management fee payments are only disallowed to the extent they are unreasonable in amount, of whether there was compensatory intent. The Tax Court failed to apply this Circuit's standard for determining whether management fees are reasonable in amount. The Tax Court committed further legal and factual errors. Appellant respectfully requests that the Court grant 15 minutes to each side for oral arguments to address the Tax Court's numerous legal and factual errors.
CORPORATE DISCLOSURE STATEMENT
Aspro, Inc. is a non-governmental corporation that is not publicly owned. Manatt's Enterprises, Ltd. and Jackson Enterprises, Corp. both own more than 10% of Aspro, Inc. Neither of those entities is publicly owned.
TABLE OF CONTENTS
SUMMARY OF CASE AND REQUEST FOR ORAL ARGUMENT
CORPORATE DISCLOSURE STATEMENT
TABLE OF CONTENTS
TABLE OF AUTHORITIES
STATEMENT OF THE ISSUES AND APPOSITE CASES
STATEMENT OF THE CASE
SUMMARY OF THE ARGUMENT
STANDARD OF REVIEW
I. THE TAX COURT ERRED AS A MATTER OF LAW IN HOLDING THAT THE MANAGEMENT FEES PAID BY ASPRO FOR THE YEARS AT ISSUE WERE NOT DEDUCTIBLE REGARDLESS OF WHETHER THE AMOUNTS WERE REASONABLE DUE TO ASPRO'S ALLEGED LACK OF COMPENSATORY INTENT
II. THE TAX COURT'S HOLDING THAT ASPRO LACKED COMPENSATORY INTENT WAS CLEARLY ERRONEOUS
III. THE TAX COURT ERRED AS A MATTER OF LAW IN HOLDING THAT NONE OF THE MANAGEMENT FEES PAID BY ASPRO WERE REASONABLE
A. THE TAX COURT ERRED AS A MATTER OF LAW BY IGNORING THE COMMISSIONER'S EXPERT'S CONCESSIONS THAT ASPRO'S SHAREHOLDERS PROVIDED VALUABLE SERVICES TO ASPRO TO JUSTIFY A PORTION OF THE MANAGEMENT FEES PAID
1. THE COMMISSIONER'S EXPERT'S CONCESSION ON JACKSON ENTERPRISES AND MANATT'S ENTERPRISES
2. THE NUNES REPORT CONCEDES, THROUGH A REPLACEMENT COST FORMULA, DAKOVICH'S TOTAL COMPENSATION WAS REASONABLE
B. THE TAX COURT ERRED AS A MATTER OF LAW BY APPLYING AN INAPPLICABLE “CUSTOMARY OF USUAL” STANDARD TO DETERMINE IF THE FEES PAID WERE DEDUCTIBLE
C. THE TAX COURT ALSO ERRED AS A MATTER OF LAW BY IGNORING BINDING PRECEDENT THAT CLOSELY HELD COMPANIES DO NOT DOCUMENT ALL OF THEIR ACTIVITIES AND DISALLOWING ALL OF ASPRO'S MANAGEMENT FEE DEDUCTIONS BASED UPON AN ALLEGED LACK OF DOCUMENTATION
D. THE TAX COURT ALSO ERRED AS A MATTER OF LAW BY HOLDING THAT THE FEES ASPRO PAID TO MANATT'S ENTERPRISES AND JACKSON ENTERPRISES WERE NOT DEDUCTIBLE BECAUSE SOME OF THE SERVICES WERE PROVIDED BY AFFILIATES OF THESE COMPANIES
IV. THE TAX COURT'S HOLDING THAT THE FEES ASPRO PAID TO DAKOVICH WERE UNREASONABLE WAS CLEARLY ERRONEOUS
V. THE TAX COURT ERRED IN DISQUALIFYING ASPRO'S EXPERTS
CERTIFICATE OF COMPLIANCE WITH FED. R. APP. P. 32
CERTIFICATE OF COMPLIANCE WITH 8TH CIR. R. 28A(H)(2)64
CERTIFICATE OF SERVICE65
TABLE OF AUTHORITIES
Alondra Indus. v. Commissioner, 1996 T.C. Memo LEXIS 31
Boyd Constr. Co. v. United States, 339 F.2d 620 (Ct. Cl. 1964)
Brewer Quality Homes, Inc. v. Comm'r, 2003 Tax Ct. Memo LEXIS 201, *32, T.C. Memo 2003-200
Cf Young & Rubicam, Inc. v. United States, 410 F.2d 1233, 1239 (1969)
Charles J. Dinardo 22 T.C. 430 (1954)
Charles McCandless Tile Service v. United States, 191 Ct. C. 108 (Ct. Cl. 1970)
Charles Schneider & Co. v. Commissioner, 500 F.2d 148 (8th Cir. 1974)
Commissioner v. Heininger, 320 U.S. 467, 468, 64 S. Ct. 249, 251 (1943)
C.T.I. v. Comm'r, 1994 Tax Ct. Memo LEXIS 83, T.C. Memo 1994-82
David E. Watson, P.C. v. United States, 668 F.3d 10080 (8th Cir. 2012)
Deputy v. du Pont, 308 U.S. 488, 495 (1940)
Elick v. Comm'r, T.C. Memo 2013-139
Federal Lithograph Co. v. United States, No. 808-71, 1975 U.S. Ct. Cl. LEXIS 541 (Ct. Cl. 1975)
Guy Schoenecker, Inc. v. Comm'r, 1995 Tax Ct. Memo LEXIS 538 (T.C. 1995)47
Jones Bros. Bakery, Inc. v. United States, 411 F.2d 1282 (Ct. Cl. 1969)40
Kinder v. Acceptance Ins. Co., 423 F.3d 899 (8th Cir. 2005)
Lohrke v. Commissioner, 48 T.C. 679 (1967)
Lutz v. Commissioner, 282 F.2d 614 (5th Cir. 1960)
Mad Auto Wrecking, Inc. v. Comm'r, 1995 Tax Ct. Memo LEXIS 146, T.C. Memo 1995-153
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987)
Pulsar Components Int'l, 1996 Tax Ct. Memo LEXIS 132, T.C. Memo 1996-129
Rts Inv. Corp. v. Commissioner, 877 F.2d 647 (8th Cir. 1989)
Smith v. Comm'r, 1965 Tax Ct. Memo LEXIS 158, T.C. Memo 1965-169
Trinity Quarries, Inc. v. United States, Civil Action No. CV 80-L-5219-NE, 80-L-5220-NE, 1981 U.S. Dist. LEXIS 13416, 48 A.F.T.R.2d (RIA) 5596 (N.D. Ala. May 2, 1981)
Trucks, Inc. v. United States, 588 F. Supp. 637 (D. Neb. 1984)
Tuf Racing Prods., Inc. v. American Suzuki Motor Corp., 223 F.3d 585 (7th Cir. 2000)
Union Carbide Corp. v. Commissioner, 2009 Tax Ct. Memo LEXIS 50, T.C. Memo 2009-50, 97 T.C.M. (CCH) 1207 (2009)
W. R. Vermillion Co. v. United States, 283 F. Supp. 350 (W.D. Mo. 1968)
Weekend Warrior Trailers, Inc. v. Commissioner, Nos. 6984-08, 6997-08, 15166-08, 2011 Tax Ct. Memo LEXIS 103 (T.C. May 19, 2011)
Wy'East Color v. Commissioner, T.C. Memo 1996-136 (Tax Court 1996)
STATUTES AND REGULATIONS
26 U.S.C. § 7442
26 U.S.C. § 6213
26 U.S.C. § 7482
26 C.F.R. 1.162-7
Aspro, Inc. (“Petitioner”) commenced this action in the United States Tax Court on August 16, 2017 for redetermination of alleged deficiencies set forth by the Commissioner of Internal Revenue (“Respondent”) in the Respondent's Notice of Deficiency dated June 30, 2017 (“Notice of Deficiency”). Jurisdiction before the Tax Court was based on 26 U.S.C. § 7442 and 26 U.S.C. § 6213. The Tax Court's Memorandum of Findings and Opinion was filed on January 21, 2021 and the Decision entered and served February 5, 2021. Thereafter, the Petitioner timely filed the Notice of Appeal on April 27, 2021. This Court has jurisdiction pursuant to 26 U.S.C. § 7482.
STATEMENT OF ISSUES AND APPOSITE CASES
I. Whether the Tax Court erred as a matter of law in holding that the management fees paid by Aspro for the years at issue were not deductible regardless of whether the amounts were reasonable due to aspro's alleged lack of compensatory intent.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1325 (5th Cir. 1987); Trinity Quarries, Inc. v. United States, Civil Action No. CV 80-L-5219-NE, 80-L-5220-NE, 1981 U.S. Dist. LEXIS 13416, at *13, 48 A.F.T.R.2d (RIA) 5596 (N.D. Ala. May 2, 1981); Charles McCandless Tile Service v. United States, 191 Ct. Cl. 108 (Ct. Cl. 1970); Boyd Constr. Co. v. United States, 339 F.2d 620 (Ct. Cl. 1964).
II. Whether the Tax Court's holding that Aspro lacked compensatory intent was clearly erroneous.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315 (5th Cir. 1987).
II. Whether the Tax Court erred as a matter of law in holding that none of the management fees paid by Aspro were reasonable.
Charles Schneider & Co. v. Commissioner, 500 F.2d 148 (8th Cir. 1974).
IV. Whether the Tax Court's holding that the management fees Aspro paid to Dakovich were unreasonable was clearly erroneous.
Trucks, Inc. v. United States, 588 F. Supp. 637, 646-47 (D. Neb. 1984); Mad Auto Wrecking, Inc. v. Comm'r, 1995 Tax Ct. Memo LEXIS 146, *14-15, *19-21, T.C. Memo 1995-153; Smith v. Comm'r, 1965 Tax Ct. Memo LEXIS 158, *16-18, T.C. Memo 1965-169; W. R. Vermillion Co. v. United States, 283 F. Supp. 350, 352 (W.D. Mo. 1968).
V. Whether he Tax Court abused its discretion by disqualifying Aspro's experts.
Brewer Quality Homes, Inc. v. Comm'r, 2003 Tax Ct. Memo LEXIS 201, *32, T.C. Memo 2003-200; Union Carbide Corp. v. Comm'r, 2009 Tax Ct. Memo LEXIS 50, *297, T.C. Memo 2009-50, 97 T.C.M. (CCH) 1207; Tuf Racing Prods., Inc. v. American Suzuki Motor Corp., 223 F.3d 585, 591 (7th Cir. 2000).
STATEMENT OF THE CASE
This case arises from the management fees that Petitioner, Aspro, Inc. (“Aspro”), paid and deducted during the tax years ending November 30, 2012, November 20, 2013, and November 30, 2014 (the “years at issue”). Aspro had three shareholders during the years at issue. Jackson Enterprises, Corp. (“Jackson Enterprises”) and Manatt's Enterprises, Ltd. (“Manatt's Enterprises”) each owned 1,500 shares equating to a 40% ownership interest each. Milton Dakovich (“Dakovich”) owned 750 shares for a 20% ownership interest. (App. 479). Historically, the Manatt family and Jackson families have been both partners and competitors in the construction industry in Iowa dating back to the 1960's. (App. 1171-1172). The original investors in Aspro were Junie Manatt, Merlin Manatt, and Robins Jackson with additional investors who were bought out in the late 1970's. (App. 3340-3345, 1172).
During the years at issue, Dakovich received total compensation for services as President including salary, bonus, and management fee of:
(App. 483). Of Dakovich's total compensation, the management fees accounted for the following portions for each year:
(App. 483). During the years at issue, Aspro paid management fees to Jackson Enterprises in the following amounts:
(App. 483). Aspro paid management fees to Manatt's Enterprises in the following amounts during the years at issue:
(App. 485). During the years at issue, Aspro's revenues averaged approximately $22.5 million. (App. 2357, 2385, 2416). The Commissioner disallowed all of Aspro's deductions for the management fees paid in the years at issue. (App. 2265-2267).
Aspro's principal place of business was located in Waterloo, Iowa at the time it filed the petition. (App. 117). Aspro's primary business is in asphalt road paving, for municipal, county, and state governments. (App. 3282). Aspro uses various sized rocks, sand, and a black liquid binding agent to make asphalt. (App. 3307-3308). Aspro's construction season runs roughly from April to the end of November. (App. 3282). From 2010 to the present, Aspro had about seventy or seventy-five employees. (App. 3287-3289). However, because Aspro's construction season ends in November, Aspro lays off most of its workforce during the winter months and then contacts employees to return in the spring. (App. 3305-3306). Aspro employs only four administrative employees including Milton Dakovich, Brad Blough as project manager and vice president, a bookkeeper and a secretary. (App. 3448-3449, 3539).
Aspro owns and operates two stationary asphalt plants in Waterloo, Iowa. (App. 3282-3283, 1079-1080). Because Aspro operates only stationary plants, they have a limited range to successfully transport asphalt without it becoming too cool and perishing. (App. 3282-3285, 1080-1081). As such, Aspro can only perform work in Blackhawk County, Iowa — where Aspro is located — and the surrounding five or six counties. (App. 3282-3285, 1080-1081). Due to the limited geographic range, Aspro must have a high rate of success on obtaining bids because there are a limited number of asphalt paving jobs available within that geographic range. (App. 3445-3446). Other asphalt companies use portable plants and can travel larger distances to work. (App. 3282-3285). However, Aspro operates by continually hauling asphalt from its plants to the worksite throughout the day. (App. 3312). Aspro intentionally remained stationary instead of obtaining portable plants so that Aspro employees would be able to go home at night as opposed to staying on the road. This has been beneficial to Aspro in recruiting and retaining qualified employees. (App. 3287-3289).
During the 2012-2014 timeframe, Aspro won a large percentage of the jobs it bid on. (App. 3445-3446). Aspro typically places bids on projects that it will perform within a given year during the fall or winter of the prior year, or in the spring of the year at issue. (App. 3297). Most of the jobs Aspro bids on are government jobs in which the lowest bid wins. (App. 3298, 1636). Generally, a bid is open for about two weeks when posted for a local entity such as the City of Waterloo. (App. 3323-3324). Plans and specifications necessary for the process of putting a bid together are not available prior to the job posting and sometimes are not available until after the bid is posted. (App. 3322, 3324-3325).
A. Services Provided by Dakovich to Aspro
Dakovich earned two bachelors' degrees in Engineering and Construction from Iowa State University and began working for Aspro in about 1979. (App. 3273-3274). Dakovich became Aspro's president in the late 1980's or early 1990's and was president during the years at issue. (App. 3275). During the years at issue, Dakovich worked at least 12 hours a day every workday year-round, while occasionally working on the weekends as well, and rarely took vacations. (App. 3314-3316). During the years at issue, Dakovich was responsible for bidding Aspro's road work successfully, overseeing the scheduling and the proper performance of the work, and maintaining the inventory for and production of Aspro's two asphalt plants. (App. 3274-3275).
In addition to his work for Aspro, Dakovich served as a member on the board of directors of the Associated General Contractors of Iowa, held a leadership role within the organization, was a National Life Director of the Associated General Contractors of America, and was a member of the board of directors of Lincoln Savings Bank during the years at issue. (App. 3277, 3279-3280, 2624). Additionally, Dakovich was appointed by the Iowa Governor to the State of Iowa Board of Regents in 2013, which governs the state's four-year postsecondary education institutions, the University of Iowa (including the University of Iowa Hospitals and Clinics), Iowa State University, the University of Northern Iowa, and two special schools for the visually and hearing impaired. (App. 3277, 3279-3280).
B. Services Provided by Jackson Enterprises to Aspro
1. Background on the Jackson/Cedar Valley Group and Steve Jackson
Steve Jackson was the President of Jackson Enterprises during the years at issue and has a degree in construction engineering from Iowa State and is a registered professional engineer. (App. 1607, 1618). Steve Jackson's father and uncle began the Jackson/Cedar Valley family of concrete paving companies in the 1950s. (App. 1608). Mr. Jackson became President of Cedar Valley Corp. in 1992 and was President of both entities during the years at issue. (App. 1610-1611, 1618). During the years at issue, Jackson Enterprises owned over 98% of Cedar Valley Corp. (App. 491). Cedar Valley Corp. owned the 40% stake in Aspro currently owned by Jackson Enterprises until mid-2010 when Jackson Enterprises took over the ownership interest. (App. 1647).
Between 2010 and 2014, Cedar Valley Corp. was primarily engaged in large-scale concrete paving for projects such as highways and airports. (App. 1612-1653). During this time Cedar Valley Corp. had around 170 employees and an extensive fleet of equipment. (App. 1613). Cedar Valley Corp. works through all of Iowa and from central Missouri to central Nebraska and performs ten to fifteen projects per year each worth between $1 million to $10 million. (App. 1614). Cedar Valley Management Corp. is an employee leasing company that houses Cedar Valley Corp.'s year-round, non-seasonal employees. (App. 1342-1343, 1347-1348).
2. Alternate Bid Consulting by Steve Jackson and Willie Calderwood
By 2010, Mr. Jackson had thirty-five years of experience in bidding concrete road paving bids. (App. 1630). William Calderwood has worked at Cedar Valley Corp. since 1980 and has a degree in construction engineering from Iowa State and is a licensed civil engineer. (App. 2037). Mr. Calderwood has been responsible for concrete bid estimating since 1986 and was in charge of Cedar Valley Corp.'s estimating department during the years at issue. (App. 1630, 2042).
During every year at issue, the City of Waterloo let out contracts for street reconstruction projects that could be done by either asphalt or concrete contractors. (App. 3297-3298, 1622, 2049). On these jobs there is a greater likelihood for potential competition from both asphalt and concrete contractors. (App. 3298-3299, 1622). The City of Waterloo would frequently not have the plans available at the time of posting the job, which created a shorter window for Aspro to prepare the job. (App. 3325).
Waterloo let out alternative bid projects for 2012, 2013, and 2014 that Aspro was awarded each year. (App. 3408). Cedar Valley Corp. does not bid on the Waterloo alternate bid projects as those jobs do not fit their business plan. (App. 1623, 2052). During those years, Steve Jackson and Willie Calderwood provided assistance to Dakovich in analyzing the alternate bid and providing Dakovich with information on where a concrete contractor may set its bid for the job. (App. 3302-3303, 1622-1624, 2051-2052). Once either Mr. Jackson or Mr. Calderwood performed an assessment, they would sit down together and confer regarding the figure one of them had reached. (App. 1632, 2051-2052, 2058). Their analysis would also include an assessment of the workload of the concrete competitors in the area and what their capacity may be to bid on the project. (App. 1622-1624, 2052-2053). Mr. Jackson and Mr. Calderwood would then verbally transmit their figures for where a concrete company may bid the alternate job to Mr. Dakovich. (App. 1634, 2058-2059). Mr. Dakovich relied upon this information to prepare Aspro's bids. (App. 3302-3303).
The alternate bid jobs for the City of Waterloo accounted for over thirty percent of Aspro's total revenue for a given year. (App. 3303-3304). If Aspro had not been able to successfully bid the alternate bid project in each given year, it would not have been able to obtain enough other work to offset the lost revenue due to its limited geographic range. Losing the bid on an alternative bid project would be devastating for Aspro and would require laying off employees during the construction season. (App. 3408-3409). Dakovich has no knowledge concrete road construction and has not alternative source for this information. (App. 3302, 3405-3407). Dakovich would be left to guess at where a potential concrete competitor would bid at the job without the help of Mr. Jackson and Mr. Calderwood. (App. 3407).
Concrete cost estimating is not a function that Aspro could contract for on a per bid basis. (App. 1617, 1714-1715, 2061-2062). The Iowa Concrete Paving Association has about twenty-five to thirty members and the four or five largest concrete companies might have two employees in charge of preparing concrete paving bids. (App. 1714). At times Aspro would face competition from concrete contractors on alternate bid jobs. (App. 3472). The assistance provided by Mr. Jackson and Mr. Calderwood played a vital role in Aspro obtaining alternate bid projects. (App. 3408). Dakovich always operated under the assumption that there would be concrete competition for the alternate bid projects because he had no way of knowing whether a competitor would bid on the job until after the bidding closed. (App. 3472, 1729-1730).
3. Human Resources Services
Aspro does not have a dedicated human resource employee and instead relied upon Jackson Enterprises (Cedar Valley) to provide those services. (App. 3403, 1758). Jeff Rost, Virginia Robinson, and Destiny Dietrick provided Aspro with those services. (App. 1374-1375, 1396). During the years at issue, Mr. Rost was the Vice President of Finance, Treasurer and Secretary of Jackson Enterprises and was in charge of Cedar Valley Corp.'s human resources operations. (App. 1372-1373, 2558). Virginia Robinson began working for Cedar Valley Corp. in 1988 and set up Cedar Valley Corp.'s human resources department. (App. 1729). During the years at issue, Aspro's office staff would call Virginia Robinson with human resources questions regarding situations facing Aspro. (App. 3411, 1397-1398, 1622, 1761-1762). Jackson Enterprises and Cedar Valley Corp. provided information to keep Aspro's employee handbook up to date. (App. 3411).
Additionally, during the years at issue, Aspro's employees participated in the self-insured health insurance plan that Cedar Valley Corp. created and administered. (App. 3413, 1621-1622, 1373-1375, 1742-1745). The Aspro plan was managed by Jeff Rost and Virginia Robinson of Cedar Valley Corp., with some input from advisor TrueNorth, during the years at issue. (App. 3413, 1494-1495, 1374-1375, 1384,1404-1405, 1742-1743). Through the plan, Aspro's employees would submit insurance claims to a third-party administrator and Cedar Valley would make payments to the third-party administrator and bill the costs to Aspro. (App. 3414-3415, 1374-1377). This healthcare plan was helpful in keeping costs down for Aspro. (App. 1379). Cedar Valley also administered dental, life insurance, and disability benefits for Aspro employees. (App. 1758-1761).
Cedar Valley also handled all the issues stemming from the implementation of the Affordable Care Act during the years at issue, which was particularly difficult for a self-insured plan. (App. 3415, 1386, 1753-1755). Ms. Robinson held meetings at least annually with Aspro management to discuss issues related to the health care plan and held annual meetings with Aspro employees to explain the plan and answer any questions. (App. 3417-3418, 1746-1749).
Destiny Dietrick was a human resources assistant for Cedar Valley from part of 2012 through 2014 and provided assistance in regard to the self-insured insurance plan. (App. 1396-1397, 1748-1749, 1755, 3570-2575). Ms. Dietrick was hired, in part, to assist with the expanding workload related to the self-insured plan. (App. 1401-1402).
Cedar Valley and Jackson never invoiced Aspro for any human resource services provided to Aspro. Jeff Rost and Steve Jackson discussed potentially billing Aspro for these services, but Mr. Jackson believed it would not be appropriate to bill Aspro on top of the management fees Aspro paid to Jackson Enterprises. (App. 1388-1389).
4. Equipment Consulting
In addition to the above services, Michael Cornelius, Cedar Valley Corp.'s Vice President of Equipment during the relevant time period, would consult with Dakovich on at least an annual basis to address Aspro's equipment issues. (App. 1642, 1577, 1587-1589). The two also attended equipment auctions together where Dakovich would seek and receive advice from Mr. Cornelius on equipment that Dakovich was interested in. (App. 1590-1591). At the time, Mr. Cornelius had been working in Cedar Valley Corp.'s equipment department for around forty years. (App. 1576-1577).
C. Services Provided by the Manatt Family of Companies to Aspro
a. Background on the Manatt Family of Companies and Tim Manatt
Tim Manatt was the President of Manatt's Enterprises during the years at issue. (App. 1069). Tim Manatt began working full-time for Manatt's family group of companies and retired in 2005. (App. 1071, 1078, 1082-1083). Tim Manatt has been on the board of Aspro continuously for between 20 and 30 years. (App. 1087). During the years at issue Tim Manatt resided in Waterloo from approximately the beginning of May to November. (App. 1131).
Manatt's Inc. is a paving contractor, asphalt contractor, and ready-mix supplier headquartered in Brooklyn, Iowa and has many different locations throughout Iowa. (App. 1068-1069). Manatt's Inc. is the wholly owned subsidiary of Manaco Corp. (App. 3036). Both Manaco Corp. and Manatt's Inc. own, directly or indirectly, interests in many companies in the state of Iowa, which generate hundreds of millions of dollars in revenue each year. (App. 3036, 1074, 1082, 1111). Originally, the entity now called Manatt's Inc. owned the Aspro shareholder interest that Manatt's Enterprises owned during the years at issue. (App. 1086, 1254). Tim Manatt is familiar with Aspro's business operations and employees. (App. 1076-1077).
b. Tim Manatt's Services to Aspro
Tim Manatt would come to Aspro's office in Waterloo nearly every business-day morning during the construction season for one or two hours. (App. 3349-3351, 1123-1126, 1135). During these meetings, Mr. Manatt and Dakovich would often discuss issues Dakovich was experiencing at Aspro, including bidding, competition, employee, and equipment issues. (App. 3349-3350, 1119-1120, 1125-1126, 1130-1131). Bob Brustkern and John Kimball, frequent Aspro subcontractors, would also come to Aspro's office in the mornings when Mr. Manatt was there. (App. 1126-1128). If Aspro was preparing a bid, Mr. Brustkern and Mr. Kimball would provide Dakovich with quotes for their subcontractor or would discuss issues related to subcontractor work they were already performing such as scheduling. (App. 1127-1130). During the winter, while Tim Manatt was living in Arizona, Dakovich would still communicate with him regarding Aspro issues including bidding. (App. 3351, 1131-1135).
Tim Manatt also manages Aspro's Vanguard fund, which contained over two million dollars during the years at issue. (App. 3353-3355, 1136-1141, 2483, 2496, 2509). At the end of 2011, the fund had a value of $1,858,947.83; $2,072,860.70 at the end of 2012; $2,306,649.96 at the end of 2013; and $2,540,366.23 at the end of 2014. (App. 2509).
Tim Manatt has also worked in the Waterloo community to ensure that the Waterloo one-cent local option sales tax continued to be used entirely for street repairs instead of splitting it between street repairs and a waterfront revitalization project. (App. 3389-3390, 3393, 1142, 1153-1154). In 2002, Tim Manatt helped lead a group call “Right to No” that opposed splitting the local option sales tax to keep the tax proceeds entirely for street repairs. (App. 3393, 1155). If the 2002 vote to split the local option sales tax had passed, it would have drastically reduced the amount of road construction projects available for Aspro to bid because the street repair projects are funded by that tax. (App. 3390, 1156-1157).
c. Environmental Services
Aspro did not have its own environmental specialist during the years at issue. (App. 3363). The environmental specialist, Mona Bond, who worked for the Manatt's Inc. family of companies during the years at issue, addressed environmental issues facing all of Manatt's Inc.'s asphalt plants including Aspro. (App. 1196-1197, 1200-1202, 1206-1207). As environmental specialist for Manatt's Inc., Ms. Bond was on call 24-hours a day to address the environmental consulting needs of any of the companies in the Manatt family. (App. 1200). During the time at issue, the EPA changed its particulate matter size standard and Ms. Bond ensured that Aspro and other Manatt plans complied with the new standard. (App. 1233).
The services Ms. Bond provided to Aspro during the relevant time included: air permitting compliance; mandatory reporting to the department of natural resources; reviewing Aspro's plant book to ensure environmental records and reading were in compliance; conducting site visits and visually inspecting stack emissions; conducting required annual training; ensuring Aspro's changes in equipment or processes were in compliance with applicable regulations; ensuring that Aspro's spill pollution prevention plan and stormwater plans were in compliance with the applicable regulations; acted as liaison between on-site environmental inspectors and the company; being called to address any environmental issue that arose for Aspro; and generally ensuring Aspro's asphalt plants were in compliance with the applicable environmental regulations. (App. 3361, 1094-1095, 1200, 1207-1209, 1213-1215, 1228-1231, 3038). Ms. Bond also kept Aspro apprised of legislation that was potentially important to Aspro. (App. 3369-3373, 1215-1217, 3098).
Additional services provided by Manatt's family of companies included safety services, best practices assistance, dredging services, bonding assistance, discounts on asphalt liquid binding product, and oil recycling.
Dan Boyer, Manatt's Inc.'s safety director, conducted on-site inspections for Aspro's construction projects in 2012, 2013, and 2014. (App. 3356-3358, 1106-1109). During this time, Mr. Boyer also made on-sight safety inspections at Aspro's asphalt plants multiple times a year. (App. 3358-3360, 1106-1109). Mr. Boyer also conducted an annual safety seminar to which Aspro employees were invited. (App. 1108).
During each year at issue, Aspro plant managers, mechanics, and supervisors were invited to discuss best practices with the entire Manatt's family of companies. (App. 3347, 3382-3383; 3534-3535, 1191-1192). There were also break out meetings two or three times a year for specific groups such as mechanics, asphalt plant operators, or road paving forepersons. (App. 3383-3384).
During the years at issue, Manatt's Inc. also provided dredging services to Aspro and dredge a stockpile of sand for Aspro's use. (App. 1103-1106). Manatt did not charge Aspro using the standard practice of billing for the sand at the time it was created, but instead allowed Aspro to pay for the sand over time as Aspro used sand from the pile. (App. 1104-1106).
During the years at issue, John McKusker prepared necessary information for, and attended, the annual surety meetings with Aspro's sureties to plan for Aspro's bonding needs in the coming year. (App. 1405-1407). Mr. McKusker was not compensated by Aspro or anyone else for this service. (App. 1406). Mr. McKusker is employed by Manatt's Inc. as a captive agent who only facilitates bonds for Manatt's affiliated companies. (App. 1400-1401).
A major component of Aspro's process of making asphalt is drying the asphalt aggregate, for which they generally use natural gas. Aspro is able to save money when natural gas prices are high by using oil from Valley Environmental. Aspro is able to obtain this recycled oil as a twenty percent owner of Valley Environmental, which Aspro had the opportunity to become a minority stake through being part of the Manatt's family of companies. (App. 3422, 1188-1190).
D. Services Provided by Both Jackson and Manatt's to Aspro
a. Discounts on Aggregate Through BMC Aggregates
Aspro buys its aggregate (rocks used in asphalt) form BMC Aggregates, LC (“BMC”). (App. 3373-337, 1117-1118, 1512-1513). Manatt's Enterprises and Jackson Enterprises owned 48.75% of BMC each during the years at issue. (App. 494). On jobs where bidding would be particularly competitive for Aspro, BMC would give Aspro a price discount on the aggregate it sold to Aspro, which was provided as a lump sum discount agreed upon between Aspro and BMC. (App. 3291-3292, 3374-3376, 1119-1121, 1643, 1520-1522).
Dakovich would communicate with BMC's Managing Member Mr. Dinsdale about this discount. (App. 3381, 1508, 1520-1522). The discounted amounts would be deducted from Aspro's costs on the bid, which resulted in a lower bid. (App. 3376). Aspro would pay the full price when it purchased the rock and then invoice BMC for the amount of the discount which would be labeled as “equipment rental” and invoiced with a job number and description of the Aspro project. (App. 3376-3378, 3381, 1520-1530, 3255). BMC does not rent equipment from Aspro, but the invoice is labeled as such to avoid pricing errors by BMC general staff. (App. 3377-3378, 1522, 1531, 1534-1535). The amount paid by BMC to Aspro would be booked as income for the job for which BMC granted the discount. (App. 3381-3382). BMC provides Aspro with these discounts because of the partial common ownership between Aspro and BMC. (App. 3374-3375, 3420).
b. Equipment Discounts
Aspro is able to receive the same price for purchasing equipment as Manatt's Inc. and Jackson Enterprises receive including for the years at issue. (Dakovich Tr. Depo. Pg. 129-130). This is because Manatt's Inc. and Jackson Enterprises purchase substantially more equipment than Aspro. (App. 3397, 3418-3420, 1111-1114, 1584).
E. Aspro's Process for Setting the Management Fees at Issue
a. Dakovich's Compensation
Dakovich received a paid salary, bonus, and managements fees during the years at issue. (App. 1177). His salary is set by Aspro's board of directors and the salary increase was based upon a small cost of living increase during the years at issue. (App. 3316, 1179-1181). Dakovich's bonus was drawn from a bonus pool for all Aspro employees and his management fee amounted to a bonus pool available to Dakovich alone. (App. 1180). Dakovich's management fee is also set by the board of directors. (App. 3316-3318). The meeting to set Dakovich's management fees occurred, and his fees were set, prior to the end of the fiscal years for which the fees were paid. (App. 3317, 1181-1182, 1188, 1652).
b. Setting Management Fees
During the years at issue, Aspro set the management fees it paid to Dakovich, Jackson Enterprises, and Manatt's Enterprises during its final meeting of the year in November. (App. 3317, 1181-1182, 1188). The board discussed the management fees at the meeting. (App. 3499-3510, 1178, 1181-1182). The directors of Aspro were aware of the services being provided by Manatt's Enterprises, Jackson Enterprises, and Dakovich in 2012, 2013, and 2014. (App. 3345-3348, 3403; 1172-1177, 1185-1187, 1649-1651, 1390-1394, 1786-1787, 1797-1799, 1801). Mr. Dakovich presented numbers to the board for consideration. (App. 1185). Due to the historical continuity of ownership and services provided to Aspro, it was not necessary for the board to spend a significant amount of time discussing what Jackson Enterprises and Manatt's Enterprises were doing as far as services provided to Aspro. (App. 3542-3543).
With the exception of 2010 (when Aspro made a major capital investment in a new asphalt plant), Aspro paid management fees for at least twenty years. (App. 1088). Aspro's board intended the management fees it paid to Dakovich to partially compensate him (in addition to his salary and bonus) for services he provided to Aspro. (App. 1187, 1652-1653, 1393-1394). Aspro's board intended for the management fees paid to Manatt's Enterprises to compensate for services that it or other Manatt's family of companies had provided to Aspro. (App. 1187-1188, 1653-1654, 1390-1391). Aspro's board intended the fees paid to Jackson Enterprises to compensate for the services the Jackson Enterprises/Cedar Valley family of companies provided to Aspro. (Id.). Aspro did not pay Manatt's Enterprises, or any person affiliated with Manatt's Enterprises, any compensation aside from the management fees during the years at issue. (App. 1190-1191). Additionally, Jackson Enterprises and its affiliated entities received no additional compensation from Aspro for the services provided outside of the management fees. (App. 1191, 1655-1657).
F. Procedural Background
On August 16, 2017, Aspro filed a petition for a redetermination of the alleged deficiencies set by the Commissioner of Internal Revenue (“Respondent”) in the Notice of Deficiency dated June 30, 2017. (App. 19). Respondent found deficiencies in Aspro's income taxes for the fiscal years ending November 30, 2012 in the amount of $370,424.00; November 30, 2013 in the amount of $544,131.00; and November 30, 2014 in the amount of $556,920.00. (App. 25-36). On October 18, 2017, Respondent filed its Answer denying Aspro's allegations of error in the Notice of Deficiency. (App. 38). The Tax Court held a bench trial from August 12-16, 2019. The Commissioner's expert, Mr. Ken Nunes, heard all witness testimony at trial. Mr. Nunes conceded that $77,340 worth of the management fees Aspro paid for the each of the years at issue was reasonable based upon services provided by the Manatt's group of companies and the Jackson/Cedar Valley group of companies. (See Nunes Expert Report at Schedule 6.2; App. 1848-1853). Mr. Nunes testified that Mr. Dakovich was not entitled to any management fee payments because his total compensation with management fees was unreasonably high.
In its Memorandum Findings of Fact and Opinion entered January 21, 2021, the Tax Court found that Aspro did not demonstrate that the management fees were paid purely for services. (App. 1034). The Tax Court held that the management fees were not deductible even if Aspro had shown the amounts were reasonable. This was based on the Court's finding that (1) Aspro had only paid management fees with no indication that it had ever paid dividends; (2) the amounts received by the shareholders “roughly correspond to their respective ownership interests;” (3) Aspro paid the corporation-shareholders instead of the individuals and individual entities that performed the services; (4) Aspro paid the management fees in a lump sum; (5) Aspro had little taxable income after the management fees were paid; and (6) the process for setting the management fees was unstructured. (App. 1034-1040). The Opinion further found that the management fees paid to the three shareholders were unreasonable.
SUMMARY OF THE ARGUMENT
In affirming the denial of all of Aspro's management fee deductions, despite the myriad of services Aspro's shareholders undisputedly provided to Aspro, the Tax Court committed multiple legal and factual errors.
First, the Tax Court erred in holding Aspro lacked a compensatory intent in paying management fees to its shareholders, and thus all of the management fee payments were non-deductible even if the payments were otherwise reasonable in amount. This Circuit has not adopted that position. Instead, management fee payments are only disallowed to the extent they are unreasonable in amount, even if the Tax Court finds the taxpayer lacked a compensatory intent in paying them.
Second, the Tax Court erred in finding Aspro lacked compensatory intent given the undisputed testimony that Aspro paid the management fees with the intent to compensate for services rendered.
Third, the Tax Court erred as a matter of law in holding that no portion of the management fees Aspro paid was reasonable in amount. The court erred in ignoring the Commissioner's concession (through its expert witness) that at least some portion of the fees Aspro paid was reasonable in amount. Regarding the management fees Aspro paid to Jackson Enterprises and Manatt's Enterprises, the Tax Court failed to apply this Circuit's standard for determining whether management fees are reasonable in amount. Instead, the Tax Court disallowed Aspro's management fee deductions based upon an erroneous application of an incorrect standard borrowed from non-management fee cases. Also, the Tax Court ignored precedent that close corporations, such as Aspro, do not document all of their activities, and used an alleged lack of documentation to disallow the management fees Aspro paid. Additionally, the Tax Court erred in holding Aspro could not pay management fees to Jackson Enterprises or Manatt's Enterprises for services rendered to Aspro by these companies' affiliates. The Tax Court offered no precedent supporting this proposition, and it is not the law.
Fourth, the Tax Court erred in holding that Dakovich's total compensation, including his management fees, was unreasonable given that he was an extremely hard-working employee who fulfilled the roles of multiple corporate officers.
Fifth, the Tax Court abused its discretion in excluding Aspro's experts under an unduly narrow interpretation of what types of expert testimony is admissible.
STANDARD OF REVIEW
“Decisions of the Tax Court are reviewable in the same manner and to the same extent as decisions of the district court sitting in civil actions without a jury.” Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 151 (8th Cir. 1974). On appeal, the Court is bound by the factual determinations of the Tax Court unless clearly erroneous or found to be unsupported by substantial evidence upon the record as a whole. Charles Schneider, 500 F.2d at 151 (citing 26 U.S.C. § 7482(a)). “A finding is clearly erroneous when although there is evidence to support it, the reviewing court on the entire evidence is left with the definite and firm conviction that a mistake has been committed.” Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1324 (5th Cir. 1987).
“The standard of review for excluding expert testimony is abuse of discretion.” Kinder v. Acceptance Ins. Cos. (In re Acceptance Ins. Cos. Sec. Litig.), 423 F.3d 899, 905 (8th Cir. 2005).
Pursuant to Section 162(a)(1) of the Internal Revenue Code, a taxpayer is permitted to deduct “reasonable allowance for salaries or other compensation for personal services actually rendered as ordinary and necessary business expenses.” Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 151 (8th Cir. 1974) (internal quotations omitted). Accordingly, payments made for management services may be deducted under section 162 if such “payments are for services actually rendered and are reasonable in amount.” Wy'East Color v. Commissioner, T.C. Memo 1996-136 (Tax Court 1996) (citations omitted).
Reasonableness of the compensation paid by a corporation is a question of fact and each case turns on its own facts and circumstances. No single factor is determinative; “rather the trial court must consider and weigh the totality of the facts and circumstances when making its decision.” Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315,1323 (5th Cir. 1987) (citations omitted). The Eight Circuit considers several factors in determining whether compensation is reasonable, including:
3. The employee's qualifications;
4. The nature, extent, and scope of the employee's work
5. The size and complexities of the business;
6. A comparison of salaries paid with the gross income and the net income;
7. The prevailing general economic conditions;
8. Comparison of salaries with distributions to stockholders;
9. The prevailing rates of compensation for comparable positions in comparable concerns;
10. The salary policy of the taxpayer as to all employees; and
11. The amount of compensation paid to the particular employee in previous years.
Charles Schneider, 500 F.2d at 151. To be deductible, the compensation must be “reasonable under all the circumstances” and “only [in] such amount as would ordinarily be paid for like services by the enterprises under like circumstances.” 26 C.F.R. 1.162-7. The Petitioner bears the burden of proving that the amount of the management fee was reasonable. Rts Inv. Corp. v. Commissioner, 877 F.2d 647, 650 (8th Cir. 2989); and Wy'East, T.C. Memo, at *20 (citing American Sav. Bank v. Commissioner, 56 T.C. 828 (1971)).
I. The Tax Court Erred as A Matter of Law In Holding That The Management Fees Paid By Aspro For The Years At Issue Were Not Deductible Regardless Of Whether The Amounts Were Reasonable Due To Aspro's Alleged Lack Of Compensatory Intent.
The Tax Court erred as a matter of law in holding that no portion of the management fees Aspro paid were deductible, even if a portion was reasonable, because Aspro allegedly lacked compensatory intent in paying them. This issue appears to be a matter of first impression in this Circuit. But the majority view is that a lack of compensatory purpose only supports the disallowance of those fees that are also not reasonable in nature.
First and foremost, the Commissioner has made it clear that, even when a Court finds a taxpayer lacked a compensatory purpose in paying and deducting management fees, the management fee deduction should only be disallowed as to the portion of the fee payment that was in excess of what was reasonable.
Treas. Reg. 1.162-7(b)(1) states:
Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock.
Thus, the Commissioner Regulations only support a disallowance of the “excessive” portion of the management fees paid on the grounds that they are disguised dividends and not payment for services rendered.
The Fifth Circuit has also held that only the deduction of the portion of the compensation paid that is in excess of what is reasonable may be disallowed, even where the Court finds a lack of compensatory purpose:
When the payments made are unquestionably at the high end of the spectrum of compensation paid within a field of work, the correlation between stockholdings and payments makes it necessary for the court to consider whether the payments are disguised dividends even if the shareholder-employees contributed services in proportion to their stockholdings. In such a case, it is not unreasonable for the court to conclude that a portion of the payments represent compensation for services and the remainder represents a disguised dividend. As noted before, the trial court must scrutinize payments made to shareholder-employees who control the corporation, especially when these payments are in proportion to stockholdings. As the regulations explain, however, even payments made to shareholders in proportion to their ownership are, as a general rule, improper only if they are in excess of what is usually paid for similar services.
Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1325 (5th Cir. 1987) (emphasis added).
In Owensby, the Fifth Circuit affirmed a Tax Court opinion that “held that a portion of the [compensation] amount paid was in reality a dividend rather than compensation for services rendered” while finding over a million dollars a year to be reasonable compensation. Id. at 1333-34 (emphasis added); see, also, Trinity Quarries, Inc. v. United States, Civil Action No. CV 80-L-5219-NE, 80-L-5220-39 NE, 1981 U.S. Dist. LEXIS 13416, at *13, 48 A.F.T.R.2d (RIA) 5596 (N.D. Ala. May 2, 1981) (“The Court concludes that a portion of the compensation in question in actuality consisted of disguised dividend distributions to the shareholders . . . The Court also concludes that the method used by the Internal Revenue Service to determine the amount of purported compensation which was attributable to actual services rendered was reasonable.”) (emphasis added); Charles McCandless Tile Service v. United States, 191 Ct. Cl. 108 (Ct. Cl. 1970) (finding that purported compensation payments were, to some extent, actually distributions of corporate earnings and that the payments were not deductible only to the extent they were considered distributions); Boyd Constr. Co. v. United States, 339 F.2d 620 (Ct. Cl. 1964) (upholding partial disallowance of directors fees based on the amount that was considered reasonable compensation); Federal Lithograph Co. v. United States, No. 808-71, 1975 U.S. Ct. Cl. LEXIS 541 (Ct. Cl. 1975) (finding that the plaintiff was allowed a deduction to the extent the salaries were reasonable compensation); Jones Bros. Bakery, Inc. v. United States, 411 F.2d 1282, 1294 (Ct. Cl. 1969) (awarding the Petitioner partial recovery for the amount of compensation paid that was based on the reasonable value of services actually provided); Alondra Indus. v. Commissioner, 1996 T.C. Memo LEXIS 31, *34-35 (upholding a partial disallowance of payments made that were in excess of reasonable costs).
The Eighth Circuit case the Tax Court relied upon for the proposition that a lack of compensatory intent invalidates all management fee payment deductions even if the payments were reasonable in amount is readily distinguishable. In its January 21, 2021 Order, the Tax Court held that:
[T]he management fees [were] not deductible even if petitioner could show the amounts were reasonable. See Charles Schneider & Co. v. Commissioner, 500 F.2d at 153 (stating that compensation paid to shareholders who set their own compensation “may be distributions of earnings rather than payments of compensation for services rendered; even if they are reasonable, they would not be deductible”).
Critically, the issue in Charles Scheinder was whether the Tax Court properly disallowed compensation paid by a family of companies to its employees above a certain amount was non-deductible as excess payment and a distribution of profits to the companies' employees. Charles Schneider & Co., 500 F.2d 148, 151 (8th Cir. 1974). The Tax Court acknowledged that a certain portion of the compensation the company paid to its employee/shareholders was reasonable compensation, and only disallowed deductions for payments above those amounts. Id. Therefore, Charles Schneider does not stand for the proposition that all of the deduction a company takes for the compensation it paid to the shareholder may be disallowed where the court finds a lack of compensatory intent in making the payment, even if a portion of the amount paid was reasonable and supported by services rendered.1
In sum, the Tax Court committed an error of law by disallowing all of the deductions Aspro took for the management fee payments it made based upon a finding of lack of compensatory intent. This is especially true where the Commissioner's expert conceded that at least of a portion of the management fees Aspro paid ($77,340 per year) were reasonable. The law simply does not support the extreme measure of disallowing all deductions for management fees paid simply based upon a finding that the fees were unreasonable in amount. Instead, the Court may only disallow those fees that are in excess of what is reasonable — which is undisputedly at least $77,340 per year.
II. The Tax Court's Holding that Aspro Lacked Compensatory Intent Was Clearly Erroneous.
In holding that Aspro lacked compensatory intent in paying the management fees that it paid, the Court simply ignored the corroborated and undisputed testimony of Aspro's directors that the management fees Aspro paid to its shareholders were intended to compensate for services rendered to Aspro. (App. 1187-188, 1652-1654, 1390-1394). These directors were all aware of the services the Manatt's group, the Jackson group and Dakovich had provided to Aspro that year (and had been providing for many years in exchange for management fee payments). (App. 3345-3348, 3403, 3542-3543, 1172-1177, 1185-1187, 1649-4651, 1390-1394, 1786-1787, 1797-1801). It was clear error for the Tax Court to disregard this undisputed testimony. Owensby & Kritikos, Inc. v. Commissioner, 819 F.2d 1315, 1323-24.
III. The Tax Court Erred as a Matter of Law in Holding that None of the Management Fees Paid By Aspro Were Reasonable.
In an alternative holding to its holding disallowing Aspro's management fee deductions based upon an alleged lack of compensatory intent, the Tax Court also affirmed the Commissioner's disallowance of all of Aspro's management fee deductions by holding that no portion of these payments was reasonable in amount. Even through there was no dispute at trial that all of the services detailed in the statement of facts above were actually provided to Aspro, the Tax Court incredibly held that none of these services were sufficient to support any portion of the management fee deduction Aspro took. This holding was erroneous as a matter of law for numerous reasons.
A. The Tax Court Erred as a Matter of Law By Ignoring the Commissioner's Expert's Concessions that Aspro's Shareholders Provided Valuable Services to Aspro to Justify a Portion of the Management Fees Paid.
The Tax Court affirmed the Commissioner's disallowance of all of the management fee payment deductions Aspro took, despite the fact that the Commissioner's own expert conceded at trial that Jackson Enterprises and Manatt's Enterprises provided valuable services to Aspro to support Aspro's management fee payments. It was an error as a matter of law.
1. The Commissioner's Expert's Concession on Jackson Enterprises and Manatt's Enterprises.
The Commissioner's expert conceded that the following people provided services to Aspro and provided his opinion of the value of those services for each of the years at issue.
Nunes Valuation Per Year( Average)
Senior Vice President Cedar Valley Corp. (App. 492.)
Concrete Bid Estimates
$2,027 (App. 4544, Table 7-3).
President of Jackson Enterprises and President and CEO of Cedar Valley Corp. (App. 1618, 492.)
Concrete Bid Estimates
$533 (App. 4544, Table 7-3).
Vice President of Finance, Treasurer and Secretary of Jackson Enterprises and Vice President, CFO, and Treasurer of Cedar Valley Corp. (App. 1618-1619, 1348, 492)
Health Insurance Services
$14,000 (App. 4544, Table 7-3).
Human Resources Manager Cedar Valley Corp. (App. 492.)
Health Insurance Services
$40,000 (App. 4544, Table 7-3).
President of Manatt’s Enterprises (App. 1069).
Strategic Consulting and Investment Advisory Services
$11,680 (App. 4546, Table 7-6, 1851-1852)
Environmental Specialist for Manatt’s Inc. family of companies (App. 1196-1197).
$9,100 (App. 1850-1851)
The Tax Court ignored the Commissioner's concession. This was an error as a matter of law, or, at the least, was clearly erroneous.
2. The Nunes Report Concedes, through a Replacement Cost Formula, Dakovich's Total Compensation Was Reasonable.
The Nunes report also confirmed that Dakovich's total compensation (including his management fee) was reasonable. Dakovich's average annual compensation for his services as President — salary, bonus and management fee — for the years at issue was $632,656. (App 483). Dakovich worked at least 12 hours a day every workday year-round, with occasional weekend work as well, and he rarely took vacations. (Dakovich Trial Depo. 46:13-48:3.) Schedule 6.3 of Mr. Nunes' report ascribes a $200 per hour rate to a president such as Dakovich. Based on 261 workdays in each of those years, working 12-hour days year-round, at a minimum, the reasonable compensation rate for Mr. Dakovich would be approximately $626,400 for each of the years at issue. Thus, Dakovich's total compensation was only slightly higher than what he would be paid at the hourly rate set forth in the Nunes Report. Mr. Nunes admitted that this $200/hour figure is the median amount an employer would need to pay for a replacement president for a company of Aspro's size and industry. (App. 1852, 2092-2093, 4532-4533 (hereinafter “Nunes Report”) Schedules 5.3 (listing median President total compensation as $229,586) & 5.4 (using this $229,586 amount to calculate $200 hourly billing rate)). This was an acknowledgement that the median replacement cost of Dakovich (assuming, without any evidence, that he could be replaced) was $626,400 per year. Because the Nunes report contemplates a median $626,400 per year cost to replace Dakovich as President, and Dakovich's total compensation was only slightly higher than the median, the Nunes report amounted to a concession that Dakovich's total compensation was reasonable. See Guy Schoenecker, Inc. v. Comm'r, 1995 Tax Ct. Memo LEXIS 538, *36-37, T.C. Memo 1995-539 (Petitioner was entitled to deduct the maximum amount of salary paid in the industry); Alondra Industries v. Comm'r, 1996 Tax Ct. Memo LEXIS 31, *44-47, T.C. Memo 1996-32 (same).
Because the Commissioner effectively conceded Dakovich's total compensation was reasonable, the Tresaury conceded that the annual average $172,000 in management fees Aspro paid Dakovich during the years at issue was reasonable.
Again, the Tax Court ignored the Commissioner's concession, by its expert's formula, that Dakovich's total compensation, and thus the management fee portion thereof, was reasonable. This was an error as a matter of law, or, at the least, was clearly erroneous.
B. The Tax Court Erred as a Matter of Law by Applying an Inapplicable “Customary of Usual” Standard to Determine If the Fees Paid Were Deductible.
The Tax Court ignored the Eighth Circuit standard for reasonable compensation and instead applied a “customary or usual” standard for whether a particular service is deductible that does not apply to management fee cases such as this one. Then the Tax Court applied that standard in an incredibly strained manner to find that the services provided to Aspro were not “customary and usual” and thus not deductible. For example, the Tax Court held that the provision of health insurance consulting services by Jackson Enterprises/Cedar Valley Corp. to Aspro was not customary or usual, and thus could not be deducted. That is simply not the law, and the Tax Court erred as a matter of law.
“Under I.R.C. § 162(a)(1), a business may deduct 'a reasonable allowance for salaries or other compensation for personal services actually rendered' as ordinary and necessary business expenses.” David E. Watson, P.C. v. United States, 668 F.3d 1008, 1016 (8th Cir. 2012) (emphasis added). Accordingly, payments made for management services may be deducted under section 162 if such “payments are for services actually rendered and are reasonable in amount.” Wy'East Color v. Commissioner, T.C. Memo 1996-136 (Tax Court 1996) (citations omitted). “Historically, [the Eighth Circuit] ha[s] applied a factors test to determine the reasonableness of compensation in the context of a business expense deduction” as set forth in Charles Schneider & Co. David E. Watson, P.C. v. United States, 668 F.3d 1008, 1016-17 (8th Cir. 2012) (citing Charles Schneider & Co. v. Commissioner, 500 F.2d 148, 151 (8th Cir. 1974).)
The Tax Court did not dispute that Aspro paid management fees to Jackson Enterprises and Manatt's Enterprises and that representatives of Jackson Enterprises and Manatt's Enterprises provided at least some services to Aspro. Because compensation for a personal services actually rendered (i.e. management fees such as those paid by Aspro) is an ordinary and necessary business expense under section 162 and this Circuit's precedent, the Tax Court should not have conducted an inquiry into whether the specific services provided to Aspro by Jackson Enterprises and Manatt's Enterprises were “ordinary and necessary.” Instead, the Tax Court should have applied the Charles Scheinder factors to determine the reasonableness of the management fees Aspro paid.
But instead, the Tax Court ignored this Circuit's Charles Scheinder factors, and incorrectly applied a “customary or usual” standard to the services provided to support Aspro's management fee payments. The Tax Court drew this “customary and usual” standard from a pair of inapposite 1940s U.S. Supreme Court cases that did not involve the payment of management fees. The Tax Court then applied that standard in a manner contrary to the undisputed evidence and common sense.
The Tax Court cited the 1940 U.S. Supreme Court case Deputy v. Du Pont for the proposition that an expense is ordinary if it is “of common or frequent occurrence in the type of business involved.” (App. 1031, citing Deputy v. du Pont, 308 U.S. 488, 495 (1940).) The Tax Court cited the 1943 U.S. Supreme Court case Commissioner v. Heininger for the proposition that “[a]n expense is necessary if it is appropriate and helpful for the development of the business.” (App.1031, citing Commissioner v. Heininger, 320 U.S. 467, 468, 64 S. Ct. 249, 251 (1943)). Neither of these cases involved the payment of management fees. The issue in Du Pont was whether an individual owner of stock in the Du Pont company could deduct fees he paid in connection with a complicated transaction of borrowing additional shares of Du Pont from a third party to sell to new executives of Du Pont. Deputy v. Du Pont, 308 U.S. 488, 492 (1940). The Supreme Court held these expenses were not ordinary and necessary expenses to the individual's business of “conserving and enhancing his estate” given how unusual the transaction was. Id. at 495. Similarly, the issue in Heininger was whether litigation expenses were ordinary and necessary expenses to the business, and thus properly deductible. Heininger, 320 U.S. at 468. Neither of these cases involved a company paying management fees, as is the case here.
Again, a company paying management fees for actual services rendered to it, as Aspro did, is ordinary and necessary, and the inquiry is whether the fees paid were reasonable in amount. The Tax Court's inquiry into whether the specific services provided to Aspro were ordinary and necessary, as opposed to reasonable in amount, was legal error.
Moreover, the Tax Court's application of the “ordinary and necessary” standard it drew from these inapposite cases was contrary to the undisputed facts and all common sense. The Tax Court held the following services the Jackson and Manatt's families of companies provided to Aspro were not “ordinary and necessary”:
Aspro's consultation with Jackson Enterprises representatives to give Aspro a picture of where a concrete company would bid a job open to both asphalt and concrete contractors. (App. 1045.) This “alternate bid” job was Aspro's largest job by far for each of the years in issue. The Tax Court's holding was that Aspro “did not establish that it is customary or usual for an asphalt paving company to pay for advice on what a concrete company may bid on an alternate bid project.” The Tax Court apparently invented a standard that every company must prove that every specific service for which it pays management fees is widely adopted in the industry, even when the service is obviously important to the company's business model. That is not the law — even when applying the (inapplicable) cases the Tax Court cited for its “ordinary and necessary” standard.
The Jackson group's management of Aspro employees' participation in a self-insured insurance plan. (App. 1045.) Again, the Tax Court applied its invented standard that Aspro needed to prove that other asphalt companies pay fees for allowing the company's employees to participate in a health insurance plan. Aspro was required to provide health insurance to its employees, and it was legal error for the Tax Court to apply a “customary and reasonable” standard to hold that Aspro paying fees to facilitate its employees getting health insurance was not deductible.
Manatt's Enterprises President Tim Manatt, a veteran senior level executive, providing consulting services to Aspro. (App. 1046-1047.)
Tim Manatt managing Aspro's multimillion-dollar investment fund. (App. 1048.)
Notably, the Commissioner's expert conceded that all of the above services had at least some value. And it is common sense that these services were all beneficial to Aspro's business operations. It was prejudicial legal error for the Tax Court to erroneously apply an “ordinary and necessary” standard to the services Jackson Enterprises and Manatt's Enterprises provided to Aspro. Instead, the Tax Court was required to determine whether the fees paid were reasonable in amount under the Charles Schneider factors. Remand is required to the Tax Court to apply these factors and properly assess the value of the services provided.
C. The Tax Court Also Erred as A Matter of Law By Ignoring Binding Precedent That Closely Held Companies Do Not Document All Of Their Activities And Disallowing All Of Aspro's Management Fee Deductions Based Upon An Alleged Lack Of Documentation.
The Tax Court also used an alleged lack of documentation by Aspro of the services provided to it as a basis to disallow all of the management fees deductions Aspro took. (App. 1041.) In doing so, the Tax Court ignored Tax Court precedent at closely held corporations, such as Aspro, “often act informally, their decisions being made in conversations, and oftentimes recorded not in minutes, but by action.” Pulsar Components Int'l, 1996 Tax Ct. Memo LEXIS 132, *37, T.C. Memo 1996-129 (internal quotation omitted). It was prejudicial legal error for the Tax Court to rely upon an alleged lack of documentation by Aspro to disallow all of Aspro's management fee deductions.
D. The Tax Court Also Erred as a Matter of Law By Holding That The Fees Aspro Paid To Manatt's Enterprises And Jackson Enterprises Were Not Deductible Because Some Of The Services Were Provided By Affiliates Of These Companies.
The Tax Court erred as a matter of law or committed clear error in holding that the management fees Aspro paid to Jackson Enterprises and Manatt's Enterprises were non-deductible because “[n]either Jackson Enterprises Corp. nor Manatt's Enterprises, Ltd., actually performed any of the 'personal services' that petitioner argues justify payment of management fees.” (App. 1043.) First, the Court's holding was erroneous because several of the individuals who provided services to Aspro were officers of Manatt's Enterprises and Jackson Enterprises. Tim Manatt was the President of Manatt's Enterprises. Steve Jackson was President of Jackson Enterprises. Jeff Rost held multiple officer positions with Jackson Enterprises. The Commissioner's expert conceded all these people provided valuable services to Aspro.
Second, as a legal matter, it is proper for Jackson Enterprises and Manatt's Enterprises to be compensated for services that their subsidiaries and related entities performed directly for Aspro's benefit. Cf Young & Rubicam, Inc. v. United States, 410 F.2d 1233, 1239 (1969) (deduction under § 162 of expenses for employees assigned by the taxpayer corporation to its foreign subsidiaries was permissible where the employees performed services for the taxpayer's proximate and direct benefit); Lohrke v. Commissioner, 48 T.C. 679, 684 (“[i]n a number of cases, the courts have allowed deductions when the expenditures were made by a taxpayer to protect or promote his own business, even though the transaction giving rise to the expenditures originated with another person and would have been deductible by that person if payment had been made by him.”); Charles J. Dinardo 22 T.C. 430 (1954) (finding that the taxpayer's payments to keep the hospital operating were deductible because they were made so the taxpayer could continue to practice medicine there and earn medical fees from patients); Lutz v. Commissioner, 282 F.2d 614 (5th Cir. 1960) (finding that expenses for corporations using taxpayer's name and brands were deductible because they were made to protect the existing goodwill of his individual business). This is especially true in regard to services provided by Virginia Robinson of Cedar Valley Corp., which is a nearly (over 98%) wholly owned subsidiary of Jackson Enterprises. To disallow fees paid to the parent based upon services by a nearly wholly owned subsidiary would be the ultimate in form over substance.
Indeed, the Tax Court did not cite any on point authority for its assertion that Jackson Enterprises and Manatt's Enterprises cannot be paid management fees based upon services provided by affiliated companies. The Elick cases the Tax Court cited does not support this proposition. (See App. 1044.) In Elick, Petitioner, a dental practice, set up a management company that was supposed to provide management services to the dental practice. Elick v. Comm'r, T.C. Memo 2013-139. The dental practice paid and deducted management fees to the management company. Id. However, the Court found “Petitioner failed to show that [the management company] rendered any services” to the dental practice. Id. The issue in Elick was a petitioner paying management fees to a sham entity. Elick did not involve, as here, fees being paid to a shareholder for services undisputedly rendered by a group of companies related to the shareholder. Elick is inapposite.
So too is the Weekend Warrior Trailer case the Tax Court cited. (See Opinion at 32.) Weekend Warrior Trailers, Inc. v. Commissioner, Nos. 6984-08, 6997-08, 15166-08, 2011 Tax Ct. Memo LEXIS 103, at *56 (T.C. May 19, 2011). Weekend Warriors simply did not involve a situation where, as here, a company paid management fees to a shareholder based upon services provided by the shareholder's affiliates. Instead, Weeekend Warroiors was a garden variety management fees case where a company paid management fees to an entity with the same ownership. Weekend Warrior Trailers, Inc. v. Commissioner, Nos. 6984-08, 6997-08, 15166-08, 2011 Tax Ct. Memo LEXIS 103, at *12 (T.C. May 19, 2011). The Tax Court held that the management fees were partially unreasonable in amount because they were not supported by adequate services. Id. at *56-*60. This case does not stand for the broad proposition that a company may not pay a shareholder management fees based upon services provided by the shareholder's affiliate. As such, the Tax Court committed a prejudicial error of law or a clear error of fact in disallowing all of Aspro's management fee deductions on this basis.
IV. The Tax Court's Holding that the Fees Aspro Paid to Dakovich Were Unreasonable Was Clearly Erroneous.
As demonstrated above, the Tax Court erred as a matter of law in ignoring the Commissioner's expert's concession (under the hourly formula he provided) that Dakovich's compensation was reasonable. To the extent this was not an error of law, this was clearly erroneous.
Further, Dakovich's total compensation is justified because the evidence shows that Dakovich performed the duties of more than one officer. Aspro had very lean administration, with only Dakovich as President, Brad Blough as project manager and vice president, and a bookkeeper and a secretary. (App. 3448-3449, 3539). Aspro had no CFO or COO, for example. This means that Dakovich was performing the work of multiple officers. In the tax refund case Trucks, Inc. v. United States, 588 F. Supp. 637, 646-47 (D. Neb. 1984), the Court criticized the expert witness' conclusions, which were based upon the preconceived roles of a chief executive officer, president, or vice president. The Court also discredited the expert for assuming the petitioners only performed the services typically fulfilled within those roles. The Court rejected the expert's conclusions, finding it was unfair to the plaintiffs who had “performed the jobs of more than one employee on a regular basis.” Id. This determination supported the Court's conclusion that the scope of the plaintiffs' duties and activities were broader than the duties of a “typical officer,” and that the government's expert witness had misjudged the plaintiffs' value to the company. Id.; see also Mad Auto Wrecking, Inc. v. Comm'r, 1995 Tax Ct. Memo LEXIS 146, *14-15, *19-21, T.C. Memo 1995-153 (finding compensation reasonable when success of company was due to the work of the shareholder-employee); Smith v. Comm'r, 1965 Tax Ct. Memo LEXIS 158, *16-18, T.C. Memo 1965-169 (finding compensation reasonable when employee-shareholders were responsible for success of highly complex company and did the work of multiple executives); W. R. Vermillion Co. v. United States, 283 F. Supp. 350, 352 (W.D. Mo. 1968) (finding compensation reasonable when employee-shareholders were responsible for a highly profitable year and performed unique services for an unusual business); C.T.I. v. Comm'r, 1994 Tax Ct. Memo LEXIS 83, *15-16, T.C. Memo 1994-82, aff'd without published opinion, 54 F.3d 767 (3d Cir. 1995) (because “[the officer's] efforts and ability were so directly and uniquely responsible for [the company's] success, we hold that the $226,000 maximum amount concluded by expert R does not represent a cap on the reasonable compensation in this case.”)
In sum, it was clearly erroneous for the Tax Court to effectively tell Aspro its extremely hard-working president was overpaid, especially where his compensation was reasonable under the Commissioner's expert's own formula.
V. The Tax Court Erred in Disqualifying Aspro's Experts.
Petitioner has submitted two expert reports. One is from Bill Kenedy, who is a CPA and is accredited in business valuation. The Kenedy report values the services provided by Petitioner's shareholders and opines on a range of compensation for the services provided that is reasonable. The other is from Gale Petersen, who has decades of experience as a principal in a major road construction company in Iowa. He has many years of experience with Aspro and its shareholders and shareholder representatives. The Petersen report opines as to what services are valuable to a company, such as Aspro, operating in the road construction industry in Iowa and whether having the positive reputations of shareholder representatives Tim Manatt and Steve Jackson associated with Aspro provided value to Aspro. The Commissioner filed a motion in limine to exclude both expert reports from evidence. The Tax Court granted the motion. In regard to Mr. Petersen's report, the Court held his testimony was in the nature of fact, and not expert, testimony. Concerning Mr. Kenedy's report, the Tax Court essentially held that it did not believe Mr. Kenedy had a scientific methodology upon which to base his opinion. Aspro proffered both expert reports at trial, and the Tax Court reaffirmed its exclusion of these reports.
The Tax Court abused its discretion by applying an unduly restrictive definition of what constitutes expert testimony to exclude Mr. Kenedy's report and testimony. First, in regard to Dakovich, Mr. Kenedy's analysis of the fees paid to Aspro shareholder Milton Dakovich, was essentially the same analysis that the Commisioner's expert Mr. Nunes conducted with respect to him — take his total annual compensation and compare it to a benchmark based upon his position with the company and the type of company. (Compare Kenedy Report at 3-4 with Nunes Report at 31-32.) It was an abuse of discretion for the Tax Court to exclude at least this portion of the Kenedy Report.
Further, the Tax Court abused its discretion in excluding Mr. Kenedy's report because it did not employ the same type of mechanistic dollars per hour or comparison to salary benchmark analysis Mr. Nunes undertook. In doing so, the Tax Court ignored its prior holding that “[t]he task of calculating a maximum amount of reasonable compensation ordinarily . . . involves judgment calls, generalizations, and very rough approximations.” Brewer Quality Homes, Inc. v. Comm'r, 2003 Tax Ct. Memo LEXIS 201, *32, T.C. Memo 2003-200. Thus, the Court is “mindful . . . that in valuation disputes (and reasonable compensation disputes are essentially a subset of valuation disputes) there is often an overzealous effort, during the course of the ensuing litigation, to infuse a talismanic precision into an issue which should frankly be recognized as inherently imprecise.” Id. (internal quotation marks omitted). In light of this, this Court admitted the report of a CPA expert witness who simply analyzed the services provided and found the compensation to be reasonable. Id. Mr. Kenedy applied a similar approach — he drew from his decade's worth of valuation experience, including extensive work in the construction space, to provide an opinion as to value of the services Aspro's shareholders provided to it. His report should therefore not be excluded. See also Union Carbide Corp. v. Comm'r, 2009 Tax Ct. Memo LEXIS 50, *297, T.C. Memo 2009-50, 97 T.C.M. (CCH) 1207 (2009) (holding in some cases there may not be published scientific methodologies available for the expert to use to opine on the issue at hand, but this does not mean that an expert cannot opine on the given subject.)
Similarly, Mr. Petersen's report properly qualified as expert testimony and should not have been excluded. Tuf Racing Prods., Inc. v. American Suzuki Motor Corp., 223 F.3d 585, 591 (7th Cir. 2000) (“The Federal Rules of Evidence, which Daubert interprets rather than overrides, do not require that expert witnesses be academics or PhDs, or that their testimony be 'scientific' (natural scientific or social scientific) in character. . . . Anyone with relevant expertise enabling him to offer responsible opinion testimony helpful to judge or jury may qualify as an expert witness.”).
For the foregoing reasons, Aspro's appeal should be granted, and the case should be remanded to the Tax Court for further factual determinations which were not included in its Opinion due to its legal errors, or the Opinion of the Tax Court should be modified to reflect the deductibility of a portion of the management fees Aspro paid, or the Court should grant further relief that it deems proper.
1Charles Schneider is also inapposite because in that case there was one controlling shareholder with a majority interest, whereas here no shareholder of Aspro had a majority interest. Charles Schneider, 500 F.2d at 153.