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.