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SAVE BIG MONEY, YOU'LL SAVE BIG MONEY...

September 16, 2004

...when you shop Menards! Surely Tax Court Judge Marvel has that little jingle burned into her brain, like the rest of us. In spite of (because of?) that catchy jingle, she handed the Eau Claire, Wisconsin-based hardware chain a defeat today in Tax Court.

The case had two issues frequently seen in successful closely-held C corporations: "excessive" compensation paid to a shareholder, and a dispute over whether expenses paid by the corporation were "business" expenses or personal expenses of the shareholder.

IS $20 MILLION EXCESSIVE FOR A YEAR'S WORK?

Closely-held C corporations find it tempting to pay large salaries and bonuses to their shareholders, rather than dividends. Why? Compensation is deductible, and dividends are not.

The IRS has for many years challenged "excessive" compensation on the ground that it is really a disguised non-deductible dividend.

John R. Menard owns 89% of Menard, Inc., personally and through various trusts. Menards has never paid a dividend. Mr. Menard often loaned back his compensation to the company. This is a set of classic "bad facts" in excess compensation cases.

The IRS asserted that only $1.3 million was reasonable for the year, while Menards said the whole $20 million was fine.

The Court ended up computing the reasonable compensation based on the compensation of its publicly-traded competitors, Lowe's and Home Depot, adjusted for Menard's higher return on equity. The Tax Court used a little algebra to come out with reasonable compensation of precisely $7,066,912:

   16.1 (HD ROR)      =        18.8 (M ROR)
$2,841,307 (HD Comp)          $ (M Comp)

M Comp = $3,317,799 x 2.13 = $7,066,912

Where M = Menards
HD = Home Depot and
the compensation of Lowe's CEO was 2.13 times that of the Home Depot CEO. Easy, huh?

MENARDS RACING TEAM: TOO MUCH FUN

Menards sponsored an Indy Racing League team in 1998. The team itself was owned by another corporation, TMI, which was in turn owned by Mr. Menard. Menards paid about $5.7 million of TMI's expenses. Of this, the Tax Court allowed Menards to deduct 4.4 million, and treated the remaining 1.3 million as a dividend to Mr. Menard.

THE MORAL?

Big, profitable closely helds are usually best-off as S corporations, rather than C corporations. S corporations are only taxed once - as the income is earned - so they don't have to fight excess compensation battles to get earnings to shareholders without a second level of tax.

It's possible Menards was ineligible to be an S corporation for some reason - perhaps having to do with its stock structure or its trust ownership. C corporations can take steps to fend off excess compensation challenges. These could have included the use of outside consultants to help set CEO compensation, the distribution of regular dividends, and avoiding the lending back of compensation to the company.

Still, they did get a nice car out of the deal.

Cite: Menard, Inc., TC Memo 2004-207

Update: The TaxProf Blog is on the story.

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