In Menard, Inc., 560 F3d 620 (7th Cir., 2009), rev'g TC Memo 2004-207 , the Seventh Circuit Court of Appeals reversed the Tax Court and found in favor of the taxpayer that a large 5% bonus arrangement payment was in fact paid for services rendered and was deductible in computing the corporation's taxable income for 1998, the year in issue. It reversed the lower court’s (Tax Court's memorandum decision) holding that the 5% bonus compensation was a disguised dividend.

Menard, Inc, was a closely held hardware and building supply company which maintained retails stores in the Midwest. It was founded by the Taxpayer, John Menard, in 1962. The year in issue was 1998, at which time the Company had grown to 138 stores and was the third largest chain store of its type. Menard owed 100% of the voting stock and 56% of the nonvoting stock. The balance of the shares were held by family members, several of whom worked in the business. The record reflected that under his stewardship, Menard caused the Company’s reveunes to grow from $788M (1991) to $3.4B (1998) and that its taxable income grew from $59M to $315M resulting in a 18.8% return which was higher than its competitors, Home Depot or Lowes. Menard’s salary in 1998 was modest, i.e., $157,000 and he received a profit-sharing bonus under a plan of slightly over $3M. He also received a 5% bonus under a program that yielded him more than $20.6M. The 5% bonus plan, which went into effect approximately 25 years earlier, was suggested by the Company’s accounting firm. It called for a bonus in the amount of 5% of net income before taxes subject to a reimbursement agreement if part of the 5% bonus were held to be unreasonable. As a result of his salary, profit-sharing bonus, and the 5% bonus, John's total compensation for the 1998 tax year exceeded $20 million. The 5% bonus also was subject to the following reimbursement agreement: In the event that the IRS disallowed as a deduction any portion of John's compensation, he had to repay to the corporation the entire amount disallowed.

Claiming the salary, profit-split and 5% bonus as deductible compensation, the IRS challenged the corporation's deduction for the entire 5% bonus to Menard as unreasonable and excessive. In response to the taxpayer’s Petitition, the Tax Court ruled that the 5% bonus was excessive and was intended to be and "looked" more like a dividend that a salary. It started its analysis by applying the independent investor test announced by the 7th Circuit in Exacto Spring Corp., 196 F.3d 833 (7th Cir. 1999). The Tax Court and the IRS agreed that John's compensation satisfied the independent investor test, but the Tax Court found the compensation paid to Menard substantially exceeded that level of compensation paid to CEOs of comparable publicly traded corporations. The Tax Court looked at what the CEO of Home Depot was paid in 1998 and that was only $2.8 million that year, even though Home Depot was a much larger company than Menards. In addition, the CEO of Lowe's, also a larger company than Menard, was paid $6.1 million. Accordingly, the Tax Court viewed: (i) Menard’s compensation substantially succeeded that paid to CEO of comparable public companies; and (ii) such evidence was sufficient to rebut the presumption of reasonableness created by the Company’s rate of return under the "independent investor" test. Looking at financial ratios among the three companies, the Tax Court concluded that only an amount slightly in excess of $7M was reasonable and that the excess portion was not intended as compensation but instead as a dividend.

The Seventh Circuit, on appeal, reversed and registered its strong disagreement with the Tax Court. It took special note of the fact that unlike a public company, owners of a closely held business there is tax incentive to treat payments from profits to some extent as compensation and not as a non-dedeductible dividend. The Court, in general, distinguished the application of the various factors when looking at a closely held corporation. It did not view the 5% of net profits bonus looked like a concealed dividend inasmuch as dividends are generally stated as specific dollar amounts rather than a percentage of earnings. Here the 5% bonus was a clear incentive for Menard to work hard and increase profits, and had no application to a passive shareholder’s waiting to realize a satisfactory rate of return.

While the Tax Court was also critical of the "one-man" determination of compensation that Menard made, since he was the sole voting shareholder, the 7th Circuit noted that such fact could not change and rejected such idea. Still, the 7th Circuit thought it would have been a slightly better argument to say that the board of directors should have sought outside advice on appropriate compensation. The record reflected however that Menard had a strong view on what the value of his services were worth.

The Seventh Circuit also discounted the argument that since the corporation had paid no formal dividend, that some portion of the compensation was a disguised dividend.

Menard sounds a major victory for paying high levels of deductible compensation employee-shareholders of closely held corporations. Still, things are no so simple and the prudent tax advisor must address the factual and legal terrain in setting forth compensation awards and programs on a go forward basis as well as in assessing potential IRS challenges under section 162 and related sections, including section 531 pertaining to the accumulated earnings tax.