Tax Law and Business Organization Strategy

Seventh Circuit Allows Closely Held Corporation to Deduct $17 Million Bonus

The Seventh Circuit reversed the Tax Court's holding that a closely held corporation could deduct only about $7 million of a $17 million CEO bonus based on a percentage of pretax net income. The appellate court's decision rejected the Tax Court's view that a repayment agreement in the event of IRS challenge was evidence that a dividend had been intended. It also rejected the Tax Court's methodology which concluded the CEO was overpaid relative to the compensation of CEOs of publicly held corporations in the same business. Menard, Inc. v Commissioner (CA 7 3/10/2009)

For an employer to deduct compensation paid, the amount must be reasonable. What's reasonable depends on the facts and circumstances of each case. The Tax Court generally applies a number of factors in determining the reasonableness of compensation, including the employer's qualifications and contribution to the company, and the employee's salary history with the company. But the Seventh Circuit in Exacto Spring rejected the Tax Court's multi-factor approach in favor a single “independent investor” test. Under the independent investor test, if a hypothetical independent investor would consider the rate of return on his investment to be far higher than he had any reason to expect, the compensation paid is presumptively reasonable. However, the presumption may be rebutted by evidence that the company's success was the result of extraneous factors, such as an unexpected discovery of oil under the company's land, or that the company intended to pay the owner/employee a disguised dividend rather than salary.

The taxpayer, Menard, Inc., is the country's third largest home improvement chain, trailing only Home Depot and Lowe's. In '98, the company operated about 160 stores in 9 Midwestern states, reporting revenue of $3.42 billion and taxable income of $315 million. John Menard is the controlling shareholder of the taxpayer (the remaining shares being held by family members and trusts). As CEO, Menard received a base salary of about $157,000. In addition, since '73 he has received an annual bonus equal to 5% of the corporation's net income before taxes. The bonus is subject to an agreement under which Menard must repay any portion of his compensation for which IRS disallowed a deduction to the corporation. The compensation of the other three corporate officers averaged about $115,000.

In '98, Menard's 5% bonus arrangement yielded him over $17 million which, when added to his salary and profit-sharing allotment, brought his total compensation for the year to over $20 million.

In 2004, the Tax Court concluded that only about $7 million of Menard's total compensation was reasonable compensation and treated the rest as a nondeductible dividend. In 2005, on reconsideration, the Tax Court upheld its determination of the approximately $7 million it found to be reasonable compensation. Now the Seventh Circuit has found that the Tax Court committed clear error in ruling that Menard's compensation was excessive in '98 and has reversed the Tax Court's ruling.

The Seventh Circuit's opinion focused on two aspects of the Tax Court's ruling: the bonus repayment agreement, and the Tax Court's settling on a $7 million reasonable compensation figure by looking at the compensation paid to similarly situated CEOs of publicly held corporations in the same field as Menard.

Bonus repayment agreement. The Tax Court said that the bonus was intended to be a dividend because Menard's entitlement to the bonus was conditioned on his agreeing to reimburse the corporation should its deduction of the bonus be disallowed by IRS or its state (Wisconsin) counterpart and because 5% of corporate earnings year in and year out “looked” more like a dividend than like salary.

The Seventh Circuit rejected these arguments as “flimsy grounds” because (a) it was prudent (and incidentally not in Menard's personal financial interest) for the company to require him to reimburse it should IRS successfully challenge the deduction; and (b) the 5% percent of net corporate income didn't look at all like a dividend. Dividends, said the Seventh Circuit, generally are specified dollar amounts—so many dollars per share—rather than a percentage of earnings. Paying a fixed (though occasionally altered) dividend gives shareholders a more predictable cash flow than if the dividend varied directly with fluctuating corporate earnings. It thus reduces the risk associated with ownership of common stock. Moreover, the reason for varying a manager's compensation with the company's profits is to increase his incentive to work intelligently and hard in order to increase those profits, and that reason has no application to a passive owner.

The Seventh Circuit also took a shot at IRS for questioning a compensation structure that had been in place for a quarter of a century and wondered whether it had just waited for Menard to “have such a great year that the IRS would have a great-looking case.”

Comparability of bonus. The main focus of the Tax Court's decision was on whether Menard's compensation exceeded that of comparable CEOs in '98 — that is, whether it was objectively excessive. In '98, the CEOs of Home Depot and Lowe's, both larger companies, were paid only $2.8 million and $6.1 million respectively. The Tax Court arrived at its reasonable compensation figure of about $7 million through the use of a formula that allowed Menard to treat as salary slightly more than twice the salary he supposedly would have earned had he been Home Depot's CEO and if Home Depot enjoyed as high a return on investment as Menard did. The Tax Court's assumption was that rate of return drives CEO compensation except for random factors assumed to have the same effect on Menard's compensation as it did on compensation paid to Lowe's' CEO (who got more than twice Lowe's CEO), even though Lowe's was a smaller company with a lower rate of return.

The Seventh Circuit termed the Tax Court's adjustment to be “arbitrary as well as dizzying” because it disregarded differences in the full compensation packages of the three executives being compared, differences in whatever challenges faced the companies in '98, and differences in the responsibilities and performance of the three CEOs. In arriving at its $7 million reasonable compensation figure, the Tax Court didn't compare the amount of work that the three CEOs did, or consider that Menard, a workaholic and head of his own company, performed tasks that would have consumed a team of people at a similarly situated company.

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