A long-standing decision against building supplies retailer Menard, in which $20 million in compensation to its founder and CEO was ruled a dividend and therefore non-deductible, has been reversed by the Seventh Circuit Court.

In 1973, Menard, now the third-largest building supplies concern after Home Depot and Lowe’s, adopted a 5 percent bonus plan at the suggestion of the company’s accounting firm.  In 1998, the bonus yielded  founder and controlling shareholder John Menard more than $17 million.  Combined with his salary and profit-sharing bonus, his total compensation for the year exceeded $20 million.

The IRS determined that the compensation was excessive and constituted a dividend, which was nondeductible by the corporation.

The Tax Court later ruled that any compensation paid Menard in 1998 in excess of $7.1 million was excessive, based in part on the ratio of the compensation of Lowe’s chief executive to that of Home Depot’s chief executive, both of which were less than Menard’s compensation that year. 

The Seventh Circuit reversed, holding that the Tax Court committed what it termed a “clear error.”  Although the Tax Court thought it suspicious that the board of directors that approved the 5 percent bonus in 1998 was controlled by Menard, the Circuit Court noted that it could hardly be otherwise, since he is the only shareholder who is entitled to vote for members of the board of directors and owns all the voting shares in the company. 

 “The logic of the Tax Court’s position is that a one-man corporation cannot pay its CEO (if he is that one man) any salary,” the court said.

The Seventh Circuit observed that just two years after Menard received his $20 million, Home Depot hired a chief executive, Robert Nardelli, who was paid $124 million over six years and received a $210 million severance package. 

 “We wonder whether the IRS plans to challenge Menard’s compensation for the years 2001 to 2006, using Nardelli’s compensation package as a basis for comparison,” the court wrote.  It noted that had Menard stores lost money in 1998, “Menard’s total compensation would have been only $157,500 – less than the salary of a federal judge -- even if the loss had not been his fault.”

The court noted that the law changed in 2003, and that the tradeoff now between dividends and salary is more complex, since the maximum tax rate for dividends is now lower than the maximum rate for salaries.  “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.”

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