Determining Reasonable Compensation - Menard Case

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, which amounted 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 companies’ rate of return and derived the formula by comparing the executive compensation paid other CEO ‘s 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 cases 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 Menard. The court looked at the following factors:

• Full Compensation packages paid the publically traded CEO’s were disregarded, such as 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, and was the Board of Directors, and held all voting shares of the company, compared to the publically traded companies, who 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. .