Menard, Inc. v. C.I.R.

• Decision Date: 10 March 2009
• Docket Number: No. 08-2125.,08-2125.
• Parties: MENARD, INC. and John R. Menard, Jr., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.
• Court: U.S. Court of Appeals — Seventh Circuit

560 F.3d 620

MENARD, INC. and John R. Menard, Jr., Petitioners-Appellants, v. COMMISSIONER OF INTERNAL REVENUE, Respondent-Appellee.

No. 08-2125.

United States Court of Appeals, Seventh Circuit.

Argued January 5, 2009.

Decided March 10, 2009.

Robert E. Dallman (argued), Reinhart, Boerner, Van Deuren, Milwaukee, WI, for Petitioners-Appellants.

Bethany B. Hauser (argued), Civil Div., Immigration Litigation, Gilbert S. Rothenberg, Deputy Assistant Attorney, Department of Justice, Washington, DC, for Respondent-Appellee.

Before EASTERBROOK, Chief Judge, and POSNER and WILLIAMS, Circuit Judges.

POSNER, Circuit Judge.

The Internal Revenue Code allows a business to deduct from its taxable income a "reasonable allowance for salaries or other compensation for personal services actually rendered," 26 U.S.C. § 162(a)(1), or, as Treas. Reg. § 1.162-7(a) adds, for "payments purely for services." Occasionally the Internal Revenue Service challenges the deduction of a corporate salary on the ground that it's really a dividend. A dividend, like salary, is taxable to the recipient, but unlike salary is not deductible from the corporation's taxable income. So by treating a dividend as salary, a corporation can reduce its income tax liability without increasing the income tax of the recipient. At least that was true in 1998, the tax year at issue in this case. As a result of a change in law in 2003, dividends are now taxed at a lower maximum rate than salaries—15 percent, versus 35 percent for salary. 26 U.S.C. § 1(h)(11). This makes the tradeoff more complex; although the corporation avoids tax by treating the dividend as a salary, which is deductible, the employee pays a higher tax.

But depending on its tax bracket, the corporation may still save more in tax than the employee pays, and in that event, if the employee owns stock in the corporation, he may, depending on how much of the stock he owns, prefer dividends to be treated as salary. Menards' tax bracket in 1998 was, its brief tells us without contradiction, 35 percent. Had the new law been in effect then, the corporation, if unable to deduct the $17.5 million bonus, would have paid $6.1 million in additional income tax, while Mr. Menard, had he received the bonus as a dividend and thus paid 15 percent rather than 35 percent of it in tax, would have saved only $3.5 million.

Even before the change in the Internal Revenue Code, treating a dividend as salary was less likely to be attempted in a publicly held corporation, because if the CEO or other officers or employees receive dividends called salary beyond what they are entitled to by virtue of owning stock in the corporation, the other share-holders suffer. But in a closely held corporation, the owners might decide to take their dividends in the form of salary in order to beat the corporate income tax, and there would be no one to complain— except the Internal Revenue Service.

The usual case for forbidding the reclassification (for tax purposes) of dividends as salary is thus that "of a corporation having few shareholders, practically all of whom draw salaries," Treas. Reg. § 1.162-7(b)(1), especially if the corporation does not pay dividends (as such) and some of the shareholders do no work for the corporation but merely cash a "salary" check. A difficult case—which is this case—is thus that of a corporation that pays a high salary to its CEO who works full time but is also the controlling shareholder. The Treasury regulation defines a "reasonable" salary as the amount that "would ordinarily be paid for like services by like enterprises under like circumstances," § 1.162-7(b)(3), but that is not an operational standard. No two enterprises are alike and no two chief executive officers are alike, and anyway the comparison should be between the total compensation package of the CEOs being compared, and that requires consideration of deferred compensation, including severance packages, the amount of risk in the executives' compensation, and perks.

Courts have attempted to operationalize the Treasury's standard by considering multiple factors that relate to optimal compensation. E.g., Haffner's Service Stations, Inc. v. Commissioner, 326 F.3d 1, 3-4 (1st Cir.2003); Eberl's Claim Service, Inc. v. Commissioner, 249 F.3d 994, 999 (10th Cir.2001); LabelGraphics, Inc. v. Commissioner, 221 F.3d 1091, 1095 (9th Cir.2000); Alpha Medical, Inc. v. Commissioner, 172 F.3d 942, 946 (6th Cir.1999); Rutter v. Commissioner, 853 F.2d 1267, 1271 (5th Cir.1988). (Alpha and Rutter each list nine factors.) We reviewed a number of these attempts in Exacto Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir.1999), and concluded that they were too vague, and too difficult to operationalize, to be of much utility. Multifactor tests with no weight assigned to any factor are bad enough from the standpoint of providing an objective basis for a judicial decision, Farmer v. Haas, 990 F.2d 319, 321 (7th Cir.1993); Prussner v. United States, 896 F.2d 218, 224 (7th Cir.1990) (en banc); Palmer v. Chicago, 806 F.2d 1316, 1318 (7th Cir.1986); United States v. Borer, 412 F.3d 987, 992 (8th Cir.2005); multifactor tests when none of the factors is concrete are worse, and that is the character of most of the multifactor tests of excessive compensation. They include such semantic vapors as "the type and extent of the services rendered," "the scarcity of qualified employees," "the qualifications . . . of the employee," his "contributions to the business venture," and "the peculiar characteristics of the employer's business."

All businesses are different, all CEOs are different, and all compensation packages for CEOs are different. In Exacto, in an effort to bring a modicum of objectivity to the determination of whether a corporate owner/employee's compensation is "reasonable," we created the presumption that "when . . . the investors in his company are obtaining a far higher return than they had any reason to expect, [the owner/employee's] salary is presumptively reasonable." But we added that the presumption could be rebutted by evidence that the company's success was the result of extraneous factors, such as an unexpected discovery of oil under the company's land, or that the company intended to pay the owner/employee a disguised dividend rather than salary. 196 F.3d at 839. The strongest ground for rebuttal, which brings us back to the basic purpose of disallowing "unreasonable" compensation, is that the employee does no work for the corporation; he is merely a shareholder. See id.; cf. General Roofing & Insulation Co. v. Commissioner, T.C. Memo 1981-667, 15-17 (1981). Other types of evidence that might rebut the Exacto presumption include evidence of a conflict of interest, though we'll see that such evidence is not always decisive. Also relevant is the relation between the executive's compensation that is challenged and the compensation of other executives in the company; for useful discussions see Rapco, Inc. v. Commissioner, 85 F.3d 950, 954-55 (2d Cir.1996), and Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir. 1983).

Comparison with the compensation of executives of other companies can be helpful if—but it is a big if—the comparison takes into account the details of the compensation package of each of the compared executives, and not just the bottom-line salary. This qualification will turn out to be critical in this case. For the Tax Court acknowledged that the presumption of reasonableness had been established but thought it rebutted by evidence that corporations in the same business as Menards paid their CEOs substantially less than Menards paid its CEO.

Menard, Inc. is a Wisconsin firm that under the name "Menards" sells hardware, building supplies, and related products through retail stores scattered throughout the Midwest. It had 138 stores in 1998 and was the third largest retail home improvement chain in the United States; only Home Depot and Lowe's were larger. It was founded by John Menard in 1962, and, at least through 1998, the tax year at issue in this case, he was the company's chief executive. (All the evidence in the record concerns his activities in that year.) Uncontradicted evidence depicts him as working 12 to 16 hours a day 6 or 7 days a week, taking only 7 days of vacation a year, working even while spending "personal time" with his family, involving himself in every detail of his firm's operations, and fixing everyone's compensation. Under his management Menards' revenues grew from $788 million in 1991 to $3.4 billion in 1998 and the company's taxable income from $59 million to $315 million. The company's rate of return on shareholders' equity that year was, according to the Internal Revenue Service's expert, 18.8 percent—higher than that of either Home Depot or Lowe's.

Menard owns all the voting shares in the company and 56 percent of the nonvoting shares, the rest being owned by members of his family, two of whom have senior positions in the company. Like the other executives of Menards, he is paid a modest base salary but participates along with them in a profit-sharing plan. In 1998, his salary was $157,500 and he received a profit-sharing bonus of $3,017,100, and the Tax Court did not suggest that there was anything amiss with these amounts. But the bulk of his compensation was in the form of a "5% bonus" that yielded him $17,467,800, as a result of which his total compensation for the year exceeded $20 million.

The 5% bonus program (5 percent of the company's net income before income taxes) was adopted in 1973 by the company's board of directors at the suggestion of the company's accounting firm, though there is no indication that the firm suggested a number rather than just advising the board that Mr. Menard should have his own bonus plan because of his commanding role in the management of the company. The board at the time included a shareholder who was not a member of Menard's family and he voted...