By: Richard Bell
This is a good case to reference in determining reasonable compensation for a shareholder who owns all voting stock and works over the top type hours in a non-publically traded company that is a C corporation for tax purposes.
Basic facts are that John Menard owns all voting shares of Menard, Inc, the third largest hardware and building supply company in the United States. Menard’s company earned $350 million in 1998 pre tax dollars the year of the audit. Menard’s compensation consisted of three components: a base salary of $157,500, a profit sharing bonus of $3,017,000, which was part of an overall compensation plan for all employees of the company, and a 5% bonus of all pre tax profits amounting to about $17.5 million, which was questioned by the IRS. Total compensation was $20 million for the year.
The US Tax Court decided that the bonus package should be driven by the company’s rate of return and derived the formula by comparing the executive compensation paid other CEOs in the industry, Lowe’s and Home Depot, and then develop a ratio of CEO compensation to the return on investment earned by each company. This ratio was then applied to the Menard’s earnings to derive the reasonable compensation of its CEO. The amount was $7.1 million, far short of the $20 million paid Menard. The IRS would have taxed the $13 million difference as a dividend. This would have increased the tax to the Menard Corporation by some estimated 40% federal and state or $5.2 million, and the dividend would have increased Menard individual tax bill by the same estimated 40% federal and state or another $5.2 million, thus, on the $13 million non allowed bonus, the tax could have been estimated as high as $10.4 million, not including penalty and interest. Menard would have received a personal refund credit for the excess bonus paid of an estimated $5.2 million, so net out before penalty and interest would have been $5.2 million. Note, this was a 1998 case before the 15% dividend rates went into effect.
The US Court of Appeals reversed the Tax Court opinion and upheld the incentive driven bonus paid to Menard. The court looked at the following factors:
• Full compensation packages paid to the publicly traded CEOs were disregarded, including stock options, severance packages, and retirement benefits.
• Differences in responsibilities and performance of the three CEO’s were different. Menard was described as micro managing the company, was the Board of Directors, and held all voting shares of the company, compared to the publicly traded companies that had executive corporate structure.
• The Appeals Court pointed out that if an incentive plan was in place for a non shareholder employee, then a shareholder employee (Menard) should be allowed to participate as well. A shareholder employee is two distinct individuals -- an independent investor and an employee.
My own observation would be to question why Menard is a C corporation for tax purposes? It would appear that the company should consider “S” corp status, but that may be the case now. This was a 1998 matter in question.
The latest court case can be found at http://caselaw.lp.findlaw.com/data2/circs/7th/082125p.pdf.
By: Richard Bell