Menard, Incorporated v. CIR

Citation: Not availableDocket: 08-2125

Court: Court of Appeals for the Seventh Circuit; March 10, 2009; Federal Appellate Court

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The case involves Menard, Inc. and its owner John R. Menard, Jr. appealing a decision from the United States Tax Court regarding the deductibility of a salary paid to Mr. Menard. Under the Internal Revenue Code, businesses can deduct "reasonable allowances for salaries or other compensation for personal services." The IRS challenges such deductions when it believes the compensation is actually a disguised dividend, which is not deductible for the corporation. In 1998, the tax implications were such that treating dividends as salary allowed the corporation to reduce tax liability without increasing the recipient's tax burden. However, tax law changed in 2003, lowering the dividend tax rate to 15% compared to 35% for salary, complicating the decision for corporations and shareholders. Menard's tax bracket in 1998 was 35%, and not being able to deduct a $17.5 million bonus would have resulted in a $6.1 million additional tax liability for the corporation, while Mr. Menard would have saved only $3.5 million by receiving it as a dividend. The case highlights issues unique to closely held corporations where shareholders may prefer to classify dividends as salaries to avoid corporate taxes, despite the potential for tax implications. The Treasury regulation defines a "reasonable" salary based on comparable compensation in similar enterprises, but this standard is challenging to apply due to the uniqueness of each corporation and executive's circumstances.

Courts have sought to clarify the Treasury’s standards for determining optimal compensation by examining various factors, as seen in cases such as Haffner’s Service Stations, Inc. v. Commissioner and Eberl’s Claim Service, Inc. v. Commissioner. Notably, the cases Alpha Medical, Inc. v. Commissioner and Rutter v. Commissioner enumerate nine factors relevant to compensation assessment. However, in Exacto Spring Corp. v. Commissioner, it was concluded that many of these multifactor tests were too vague to provide a reliable basis for judicial decisions. Such tests often contain ambiguous criteria, like "the type and extent of services rendered" and "the qualifications of the employee." To introduce objectivity, Exacto established a presumption that if investors are receiving higher-than-expected returns, the owner/employee’s salary is presumptively reasonable, unless countered by evidence suggesting the company's success resulted from unrelated factors or that the compensation was a disguised dividend. A key factor for rebuttal is if the employee does not perform work for the corporation, merely holding shares. Evidence of conflicts of interest and comparisons to other executives’ compensation within the same company or industry may also serve as rebuttals, although the latter must consider the specifics of each compensation package. In the case involving Menard, Inc., while the presumption of reasonable compensation was acknowledged, it was challenged by evidence that Menards’ CEO was paid significantly more than peers in similar businesses. Menard, Inc. is a prominent retail home improvement chain, founded in 1962 by John Menard, who was CEO at least through 1998, the tax year in question.

Uncontradicted evidence shows that Menard worked extensively, averaging 12 to 16 hours daily for 6 to 7 days a week, taking only 7 vacation days annually, and even working during family time. Under his leadership, Menards’ revenue increased from $788 million in 1991 to $3.4 billion in 1998, with taxable income rising from $59 million to $315 million. The company achieved an 18.8 percent return on shareholders' equity, surpassing competitors Home Depot and Lowe's. Menard owns all voting shares and 56 percent of non-voting shares, with family members holding the balance. His compensation includes a modest salary of $157,500 and a profit-sharing bonus of $3,017,100, with the majority coming from a 5% bonus linked to net income before taxes, totaling over $20 million in 1998. The 5% bonus plan was established in 1973 and had not been reexamined by the board, which included a non-family shareholder at its inception. The Tax Court viewed the bonus as excessive and potentially a disguised dividend due to the reimbursement clause if the IRS disallowed the deduction and the nature of the 5% calculation. However, this characterization is deemed weak, as the reimbursement requirement aligns with IRS practices, and the structure of the bonus differs fundamentally from how dividends are typically distributed.

A fixed dividend, though occasionally modified, provides shareholders with a more stable cash flow compared to dividends tied to fluctuating corporate earnings, thereby reducing the risk associated with common stock ownership. Unlike shareholders, managers have their compensation linked to profits to incentivize performance, a rationale not applicable to passive owners. The Tax Court viewed Menard's 5 percent year-end bonus as indicative of a "concealed" dividend, despite the practicality of year-end payments when earnings are finalized. Bonuses are typically paid in lump sums annually, while dividends are usually distributed quarterly. The Tax Court expressed concern over Menard controlling the board that approved his bonus, suggesting a one-man corporation might not justifiably compensate its CEO, which the court found questionable. The lack of external compensation advice from the board raised further suspicion, though it could be seen as a mere formality. The absence of formal dividends led to speculation that Menard's compensation could be classified as a dividend; however, many corporations retain earnings for capital investment, and the rationale for dividends does not apply to Menards due to the close alignment of management and ownership. The Tax Court primarily focused on whether Menard's compensation was excessive compared to other CEOs, especially given that the CEO of Home Depot earned $2.8 million and Lowe's CEO earned $6.1 million, underscoring the complexity of assessing compensation beyond salary alone, particularly regarding risk in the compensation structure.

Risk in corporate compensation poses two main challenges. First, managers, who are typically more risk averse than shareholders, may hinder effective corporate management due to their reluctance to embrace risk. Shareholders can mitigate individual company risk through diversification, whereas managers often have significant financial, reputational, and specific human capital tied to their positions. Consequently, a riskier compensation structure necessitates higher salaries to compensate executives for the increased risk. However, this consideration is less relevant in the case of Menards, where management and ownership are closely linked.

The second challenge relates to the variability in an executive's salary under a risky compensation structure, which can fluctuate significantly based on company performance. For instance, Mr. Menard's average annual income might be under $20 million, a factor overlooked by the Tax Court. If Menards incurred losses in 1998, Menard's total compensation could have dropped to $157,500, below that of a federal judge, regardless of fault. The Tax Court also failed to account for severance packages, retirement benefits, and other perks when comparing Menard's compensation to other CEOs, despite the substantial impact these elements can have on overall executive pay.

Additionally, a comparison is drawn with Robert Nardelli, former CEO of Home Depot, who earned $124 million over six years and received a controversial $210 million severance upon his departure. The IRS's potential challenge to Menard's compensation for 2001 to 2006 is speculated, particularly in light of Nardelli's package. The Tax Court determined that Menard's compensation in 1998 exceeded $7.1 million, deriving this figure through a calculation based on the return on investment ratios of Home Depot and Menards, resulting in a figure slightly above twice what Menard would have earned as Home Depot's CEO.

The judge posited that CEO compensation is primarily driven by the rate of return, yet this assumption was challenged by the disparity in compensation between the CEOs of Lowe’s and Home Depot, despite differences in company size and performance. The analysis was criticized for being arbitrary, as it overlooked variations in overall compensation packages, the specific challenges faced by the companies in 1998, and the distinct responsibilities and performance levels of the CEOs involved. 

There was insufficient information on the compensation of senior management at Menard compared to that at Home Depot and Lowe’s, raising questions about Menard’s role—whether he was performing tasks typically carried out by a larger executive team or if he was underperforming, with staff handling the bulk of the work. Evidence suggested that Menard was highly involved in the company's operations, implying a greater degree of responsibility. 

The Tax Court's skepticism about Menard’s compensation was noted, particularly its suggestion that as the company owner, Menard had sufficient incentive to work hard without a salary. This position was criticized, as it implied that a reasonable salary could be zero, despite Menard being allowed to deduct $7.1 million in salary for tax purposes. The court emphasized that shareholder-employees should be treated like any other employees for compensation purposes. 

The discussion referenced precedents indicating that a controlling shareholder could still be entitled to bonuses based on performance, rather than solely on ownership status. The conclusion was that the Tax Court erred in deeming Menard's compensation excessive, leading to a reversal of its decision.