New Federal Appellate Decision Provides Welcome Guidance on Determination of Reasonable Compensation

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Corporate & Finance Alert

May 5, 2009

Section 162(a) of the Internal Revenue Code provides a deduction for reasonable compensation paid to employees. In the closely-held corporation context, the corporation has a strong motivation to pay employees who are also shareholders compensation, rather than dividends. The payment of compensation is deductible by the corporation, but the payment of dividends is not. Furthermore, when corporate income tax rates are greater than the difference between individual tax rates on compensation and individual tax rates on dividends, the corporation often seeks to pay employee-shareholders compensation rather than dividends.

The Treasury Regulations define reasonable compensation as the amount that would ordinarily be paid for like services by like enterprises under like circumstances. Since this is an amorphous standard that is difficult to apply in operation, the Seventh Circuit Court of Appeals in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), developed the following standards to bring a degree of certainty in the area. The court created the presumption that when the investors in a corporation are obtaining a far higher return than they had reason to expect, the employee-shareholder’s salary is presumptively reasonable.

The IRS could rebut the presumption by evidence that the corporation’s success was the result of extraneous factors, such as an unexpected discovery of oil under the corporation’s land, or that the corporation intended the pay the employee-shareholder a disguised dividend rather than salary. The strongest ground for rebuttal is that the employee did not do any work for the corporation, and that the employee was merely a shareholder. Other types of evidence that might rebut the presumption include evidence of conflict of interest, and the relationship between the employee-shareholder’s compensation and the compensation of other executives in the corporation and in the industry.

In the recent case of Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), the Seventh Circuit Court of Appeals elaborated on these standards. Menard, a Wisconsin corporation, sold hardware, building supplies, and related products through retail stores throughout the Midwest. It had 138 stores in 1998, the taxable year at issue, and was the third largest retail home-improvement chain in the United States. Only Home Depot and Lowe’s were larger.

Menard was founded by John Menard in 1962, and through 1998 he served as the company’s chief executive officer. Uncontradicted evidence showed that he worked twelve to sixteen hours a day, six or seven days a week, and took only seven days of vacation per year. Under his management, the company’s revenues grew from $788 million in 1991 to $3.4 billion in 1998, and its taxable income from $59 million to $315 million. The company’s rate of return on shareholder’s equity in 1998 was 18.8%, which was higher than that of Home Depot and Lowe’s.

John Menard owned all the voting shares, and 56% of the nonvoting shares, the rest being owned by members of his family, two of whom had senior positions in the company.

In 1998, John Menard had a base salary of $157,500, and a profit-sharing bonus of $3,017,100. He also received a bonus of $17,467,800, which represented 5% of the company’s net income before income taxes. The 5% bonus program was adopted in 1973 and continued in effect through 1998.

The Tax Court held that John Menard’s total compensation exceeding $20 million was unreasonable, and limited the deductible compensation to $7.1 million. The Tax Court relied on two grounds. First, it found that the compensation was intended as a dividend because the 5% bonus was conditioned on the employee-shareholder’s agreement to reimburse the company should the deduction of the bonus was disallowed by the Internal Revenue Service or the Wisconsin tax authority.

Second, John Menard’s compensation exceeded that of comparable CEOs in 1998. The CEO of Home Depot was paid $2.8 million in 1998, though it was a much larger company. In addition, the CEO of Lowe’s, also a larger company, was paid $6.1 million.

The Seventh Circuit Court of Appeals held that the Tax Court committed clear error, and upheld the deductibility of the entire compensation. The Seventh Circuit rejected the dividend characterization. Dividends generally are specified dollar amounts, rather than a percentage of earnings. When earnings fall, dividends may be cut, but they are cut from one fixed amount to another, rather than made to vary as a percentage of earnings.

Moreover, the reason for varying a manager’s compensation with the company’s profits is to increase the manager’s incentive to work intelligently and hard to increase those profits, and that reason has no application to a person who is merely a passive shareholder. Furthermore, the contractual obligation to reimburse the company should the IRS successfully challenge the deduction was prudent, and not in John Menard’s personal financial interest.

The Seventh Circuit then rejected the Tax Court’s analysis that John Menard’s compensation exceeded that of comparable CEOs in 1998. The 5% bonus structure carried the risk of varying based on the company’s earnings. The executive’s salary is likely to vary substantially from year to year; high when the company has a good year, and low when the company has a poor year.

In addition, the Tax Court did not consider the entire compensation packages of the CEOs of Home Depot and Lowe’s, such as severance packages, retirement plans, and perks. Just two years after John Menard received his 1998 compensation, Robert Nardelli became the CEO of Home Depot. In his slightly more than six years as CEO, he was paid $124 million dollars in salary, exclusive of stock options. When he was terminated in 2007, he received a severance payment of $210 million, including the value of his stock options.

Finally, the Seventh Circuit pointed out that John Menard worked extraordinarily hard, and did the work that other companies delegated to staff.

In light of the Seventh Circuit’s decision, closely-held corporations have strong grounds to justify the compensation paid to employee-shareholders. To bolster this justification, closely-held corporations should consider taking and documenting the following actions close to the time that the employee-shareholder commences the performance of services giving rise to the compensation.

First, the corporation and the employee-shareholder should enter into a binding written employment agreement. Second, the corporation and the employee-shareholder should consider compensation over a period of years, especially when compensation in prior years may have been inadequate. Third, the corporation should gather data about similarly situated companies, and similarly situated executives. Finally, the corporation should consider the investment criteria that an independent investor would consider if the investor were to invest in it.

Should you have any questions regarding your own situation, please contact Steven H. Sholk of our Corporate Department.