Tax Court’s Adjustment to Reasonable Compensation ‘Dizzying and Arbitrary’

Menard v. Commissioner, 2009 WL 595587 (C. A. 7)(March 10, 2009)

The CEO of The Home Depot was paid $2.8 million in salary in 1998. The CEO of Lowe’s received $6.1 million (neither including bonus). Yet when the CEO of the nation’s third largest retail home improvement chain, Menards, posted roughly $20.6 million in salary (including bonus), the IRS stepped in and disallowed $19 million as a corporate deduction.

The reason: The IRS claimed that it was a disguised dividend.

The Tax Court applied a unique formula.

The CEO, John Menard, founded the Wisconsin-based Menards hardware stores in 1962. He worked six or  seven days a week, up to 16 hours a day, and was involved in every detail of company operations. Under his management, revenues grew from $788 million in 1991 to $3.4 billion in 1998. The company’s return on shareholder equity in 1998 was 18.8%. By contrast, Home Depot returned a 16.1% return on investment that year, and Lowe’s rate of return was lower.

Menard owned all the voting shares in the company and 56% of the non-voting shares. He was paid a  modest base salary and a portion of a profit-sharing plan; in 1998, he earned $157,500 and $3 million from these sources. A bonus program, adopted by the board of directors in 1973, for his “commanding” management role, awarded him an additional 5% of company earnings (before taxes) at the end of each year. In 1998, the 5% bonus yielded the CEO an additional $17.5 million, conditioned on the IRS allowing its deduction from corporate income.

At trial the IRS not only persuaded the Tax Court that the bulk of the CEO’s compensation was excessive, but that because it was conditional and paid at year’s-end, it was also intended as a dividend, especially since the company didn’t pay formal dividends to other shareholders.

As to the “excess”, the Tax Court found that any compensation above $7.1 million for Menard was too much. The court used its own unique formula to arrive at this conclusion:

  1. Divide Home Depot’s return on investment (16.1%) by its CEO’s salary ($2.84 million);
  2. Divide Menard’s return on investment (18.8%) by the result of step (1); and then
  3. Multiply the result ($3.32 million) by 2.13, or the ratio of the compensation of Lowe’s CEO to that of Home Depot’s CEO.

The appellate court considered the Tax Court’s formula an arbitrary and dizzying adjustment. It disregarded differences in the full compensation packages of the three executives being compared (the Home Depot CEO made more than $124 million
from 1998-2004) , differences in whatever challenges faced the companies in 1998, and differences in [their] responsibilities and performances (Menard was by far the most active, hard-working).

Not a concealed dividend.

The Tax Court ignored the substantial level of risk in Menard’s compensation structure, given its direct tie to company earnings. Not to mention the fact that the 5% bonus program had been in place for 25 years before the IRS “pounced,” the court said. It did not look like a dividend, because corporate dividends are generally tied to specific dollar amounts and do not serve the same incentive purpose to the passive shareholder.

The Seventh Circuit reversed the Tax Court’s decision.

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The Importance of Valuing Your Business

Dear Clients and Colleagues:

The following article was written by Steve Parrish of Forbes Magazine, August 14, 2012 edition. I think you’ll find it interesting and enjoyable.

Sincerely,

Thomas G Stevenson, CPA, CVA

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IF YOU VALUE YOUR BUSINESS,

YOU SHOULD VALUE YOUR BUSINESS

At this year’s Berkshire Hathaway annual meeting, Warren Buffett made a key point all business owners should pay attention to:

“If business schools could offer just one course, it would not be on stock trading, the efficient market hypothesis or modern portfolio theory. Rather, B-schools should be encouraging students to learn the boring, but critically important, discipline of business valuation.”

If you already own a business, why would you need this skill? You’d need it only if any of the following apply:

  •  You may someday retire, sell, or leave your business.
  • You might die or become disabled.
  • You have key employees or partners whom you’re trying to motivate to be more efficient, productive or otherwise profitable.
  • Creditors, predators, or soon-to-be ex-spouses may someday want a piece of your business.

If none of these applies, carry on with your business … after you seek psychological counseling. If some of these do apply, however, consider having your business valued. And, as the Oracle of Omaha stated, learn something about the process yourself. Just because your lawyer drafts your will doesn’t mean you shouldn’t know something about wills, and even though your accountant does your books, you still need to understand financial principles. The same applies to the valuing of your firm. Business valuation is a process done by professionals, but it’s a product the business owner needs to understand.

Valuing a privately held business can be complex, but the overall process can be simply explained. A standard — what I’ll call “baseline” — business valuation seeks to address three basic questions:

What is the value of the business’s assets?

  1. What is the value to an outside party of the firm’s ongoing business (for example: revenues, profits or brand)?
  2. What does the current market look like for similar businesses (comparable sales, what banks are lending on, etc.)?

A business valuation is an amalgam of answers to the above questions. And the valuation will typically be unique to each business, sector and industry.  Consider three simple examples: a farm, a dental practice, and an online retailer.

With a farm, the assets are a primary consideration. How many acres, what farm machinery is in the operation, and what loans are there? Because the end product — the crop — is a commodity, differentiation between one farm and another is difficult to achieve. So a valuation would look at the hard assets, see what other acreage in the area is selling for, and from these answers, a baseline valuation could be created.

A dental practice involves a combination of earnings and assets intrinsic in the valuation. The practice includes hard assets like chairs and x-ray machines, but it also has a customer base that religiously returns every six months for a cleaning. So a valuation would hone in on the historical profit of the practice and try to project forward how large and loyal the customer base is. The valuation would seek to answer the question: how many months or years of profits could a purchasing dental firm expect to yield from the practice? A look at comparable dental practices in the geographic region would help further refine the process. Add in the value of the hard assets, and — voila! — you have a baseline valuation.

The valuation of an online retailer may be more challenging, but manageable.  Beyond any inventory the retailer owns, the hard assets may be few.  But there are likely two other asset types that need to be considered. One is the kind that goes home at night: the employees who buy, market, and service the accounts. The other asset is the online brand the company has created.

Would an independent buyer find value in leveraging the business’s online presence and reputation?  Finding comparable businesses that sell in cyberspace offers fewer historical examples than farms or dental practices, but a positive feature is that the value of an online business is less likely to be geographically affected. The baseline valuation for an online retailer will probably include the inventory and a capitalization of earnings, revenues, and whatever other key metric is used to value such a business. For example, the business’s growth trend is likely to be a key measure in this kind of industry.

Taking this baseline valuation and massaging it to recognize the unique features of the business, the reason for the valuation, and the timing may that apply is a topic for future articles. But the message is still simple: A business owner should have the business valued, and should understand the principles of the valuation. It seems to have worked well for Warren.

 

Experts in Court Round-up

Dear Friends,

In many cases, the need for a valuation expert is obvious and inescapable, which raises the question of how to choose and use an expert to the best advantage for a legal argument. Recent case law offers some tips in answer to this question.

It doesn’t pay to skimp.

In Villaje del Rio, Ltd. V. Colina, L.P., 2009 WL 1606431 (W.D. Tex.) (June 8, 2009), the developer/plaintiff tried to cut costs by designating himself an expert to testify in regards to the value of his own real estate project, and supplemented his own with two experts’ testimony, based on appraisals they prepared in connection with the project’s financing, two years prior to the insolvency at issue. The court struck the appraisal experts for their failure to consider the relevant facts and data of the actual insolvency, and the plaintiff as well, saying, “lay testimony results from a process of reasoning familiar in everyday life, while expert testimony results from a process of reasoning which can be mastered only by specialists in the field.”

A cost efficient compromise.

Although a plaintiff often has no choice but to present an expert, the defendant may have other options. In Sossikian v. Ennis, 2009 WL 2106106 (Cal. App. 1 Dist.) (July 16, 2009) (unpublished), the defendant found an ideal solution, by using an expert for rebuttal purposes only to discredit the damages evidence offered by the plaintiff’s expert. This choice left the jury with no basis for a damages award and they awarded $42,182 on the plaintiff’s $800,000 claim.

Who is qualified?

When you make the decision to incur the cost of an expert, you want to make sure it’s the right one. In MDG Internat’l v. Australian Gold, Inc., 2009 WL 1916728 (S.D. Ind.) (June 29, 2009), an otherwise “supremely qualified” expert failed to satisfy the requirements of the Federal Rules of Evidence and Daubert. The expert, a professor of accounting and chair of an accredited MBA program deeply experienced in valuing public companies, was engaged to value a private company. The court concluded that he lacked the requisite “knowledge, skill, experience, training, or education” to testify regarding the value of the closely held business at issue, and went on to find that the expert’s opinions and methodologies were riddled with deficiencies. “Expert” is not broadly defined. It is critical to engage someone experienced in the particular issue of the case.

Of course, there are always outlier situations.

Chick-Fil-A v. CFT Development, LLC, 2009 WL 1754058 (M.D. Fla.) (June 18, 2009) is one such case. At issue was whether Panda Express (the defendant), which was proposed to be built next to a Chick-Fil-A, would derive 25% or more of its gross sales from the sale of chicken (and thus be enjoined from opening under a restrictive covenant on the property). The plaintiff’s and defendant’s experts proposed alternative methods of calculating the 25%, and both parties filed Daubert motions, claiming the other’s expert was unreliable or irrelevant. In the absence of any precedents (legal or accounting) on how to calculate the percentage of sales from chicken (for example, does it include non-chicken ingredients in a chicken dish?), the court permitted both experts to testify, saying that “the certainty and correctness will be tested through cross-examination and presentation of contrary evidence.”

Not all experts face the Daubert test.

Certain states continue to use a hybrid of that new federal rule and their own standard, based on the so-called Frye rule (from Frye v. United States, 54 App. D.C. 46 (1923)), even though Daubert overruled that case. The Frye test requires that an expert’s opinion derive from a principle that is “sufficiently established to have gained general acceptance in the particular field in which it belongs.” This was the test used by the court in 8000 Maryland LLC v. Huntleigh Financial Services, Inc., 2009 WL 2144895 (Mo. App. E.D.) (July 21, 2009). There the court of appeals affirmed that the plaintiff’s expert, a CPA/ABV, ASA, CVA with a master’s degree in finance and twenty-five years experience valuing public and private companies, had based her conclusions on facts and data reasonably relied on by similar experts.

Watch your expert’s language.

You’ve hired an expert. They’ve passed the hurdle of court acceptance. They give their opinion. It goes without saying (or does it?) that that opinion needs to be powerful, well presented, and not based on speculation. In Lucent Technologies, Inc. v. Gateway, Inc., 2009 WL 2902044 (C.A. Fed.) (Sept. 11, 2009), the plaintiff’s expert’s patent damages calculation, which resulted in a jury award of $358 million, was thrown out (and the jury award reversed), based largely on the expert’s testimony that to calculate a lump-sum amount (of damages), the parties might start by looking at the running royalty “and then speculating as to the extent of the future use” (emphasis by court). Perhaps it was semantics, (the expert might just as easily have said “estimate”), but the court held that what it dubbed the “lump sum speculation theory” improperly suggested guesswork, not rigorous analysis. The court went on to bolster its decision, finding that the expert’s comparables had no probative value, as the technology at issue was unique and difficult to compare meaningfully.

The bottom line: it pays to hire an expert, but be sure it’s the right expert doing the best job possible.