Menard, Inc. v. Commissioner
560 F.3d 620, 2009 U.S. App. LEXIS 4883, 103 A.F.T.R.2d (RIA) 1280 (2009)
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Rule of Law:
Compensation paid to a controlling shareholder and CEO of a closely held corporation is presumptively reasonable and deductible for tax purposes if the company's investors are receiving a high return, and this presumption is not easily rebutted by superficial comparisons to other executives' salaries or by circumstances that do not inherently indicate a disguised dividend.
Facts:
- Menard, Inc. is a Wisconsin firm that operates retail home improvement stores, growing to 138 stores and $3.4 billion in revenues by 1998, making it the third largest chain in the U.S.
- John Menard founded the company in 1962 and was its CEO in 1998, working 12-16 hours a day, 6-7 days a week, and involving himself in every detail of the firm's operations.
- Under John Menard's management, the company's taxable income grew to $315 million in 1998, and its rate of return on shareholders' equity was 18.8%, exceeding that of larger competitors like Home Depot and Lowe's.
- John Menard owns all the voting shares and 56% of the nonvoting shares of Menard, Inc., with the remaining nonvoting shares held by family members.
- In 1998, John Menard's total compensation exceeded $20 million, consisting of a $157,500 base salary, a $3,017,100 profit-sharing bonus, and a $17,467,800 '5% bonus' (5% of the company's net income before income taxes).
- The 5% bonus program was adopted by the company's board of directors in 1973, which at the time included a non-family shareholder who voted for the plan.
- Menard's entitlement to the 5% bonus was conditioned on his agreeing to reimburse the corporation if the deduction of the bonus was disallowed by tax authorities.
- Menard, Inc. paid no formal dividends to its shareholders.
Procedural Posture:
- The Internal Revenue Service (IRS) challenged Menard, Inc.'s deduction of John Menard's $17.5 million '5% bonus' from its taxable income for the 1998 tax year, arguing it was a disguised dividend.
- The Tax Court ruled that any compensation paid to John Menard in 1998 in excess of $7.1 million was excessive and thus constituted a non-deductible dividend.
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Issue:
Does compensation paid to a controlling shareholder and CEO of a closely held corporation, when the company's investors are receiving a far higher return than expected, qualify as a 'reasonable allowance for salaries' under 26 U.S.C. § 162(a)(1) for tax deduction purposes, or is it a disguised dividend, especially when the Tax Court relies on an incomplete comparison to other executives' compensation?
Opinions:
Majority - Posner, Circuit Judge
Yes, compensation paid to a controlling shareholder and CEO of a closely held corporation, where investors receive a high return, can be a 'reasonable allowance for salaries' for tax deduction purposes, and the Tax Court erred in finding John Menard's compensation excessive. The court criticized the Tax Court's reliance on vague, multi-factor tests and its arbitrary method for determining excessive compensation. The Seventh Circuit, reaffirming its test from Exacto Spring Corp. v. Commissioner, held that when a company's investors are receiving a far higher return than they had any reason to expect, the owner/employee's salary is presumptively reasonable. This presumption was established here, as Menards' return on equity was 18.8%. The court found the Tax Court's reasons for rebutting this presumption to be flimsy. These included the reimbursement agreement (which was prudent), the percentage-based bonus (which incentivizes performance and differs from typical dividends), the year-end payment schedule (common for bonuses), John Menard's control of the board (inevitable in a single-shareholder company), and the lack of formal dividends (common for corporations that retain earnings). The court emphasized that comparing CEO compensation must consider the full compensation package, including risk, severance, retirement plans, and perks, not just base salary. The Tax Court's comparison to Home Depot and Lowe's CEOs was flawed because it ignored these critical factors and the fact that John Menard performed tasks that in larger companies are delegated to more staff or boards.
Analysis:
This case significantly reinforces the Exacto Spring test for determining reasonable compensation in closely held corporations, particularly when the CEO is also a controlling shareholder. It clarifies that a high return on investment for shareholders creates a strong presumption of reasonableness, which is difficult to rebut. The ruling provides crucial guidance by rejecting simplistic comparisons of executive salaries and emphasizing the need to consider the entirety of an executive's compensation package, including the risk component and the scope of their responsibilities. This decision empowers closely held businesses to pay their highly effective owner-executives substantial performance-based compensation without automatic reclassification as a dividend by the IRS, as long as investor returns are strong.
