The Seventh Circuit Court of Appeals reversed a Tax Court decision that held that most of an executive’s $20 million compensation was unreasonable and therefore a nondeductible dividend (Menard, Inc., No. 08-2125 (7th Cir. 3/10/09), rev’g T.C. Memo. 2005-3).
John Menard is founder and CEO of Menard Inc. In 1998, he earned a salary of $157,500, a profit sharing bonus of $3 million and a “5% bonus” of $17.5 million, based on the company’s net income for the year. Menard had received a 5% bonus every year since 1973.
Under IRC § 162, a business can deduct a “reasonable allowance” for salaries and other compensation paid, but cannot deduct amounts paid as dividends (section 301(c)). The Tax Court held that the 5% bonus was a disguised dividend and did not allow the company to deduct more than $7.1 million in compensation, the amount the court calculated was reasonable, based on the pay of CEOs at similar companies.
The Seventh Circuit’s opinion, written by Judge Richard Posner, disparaged as “flimsy” the Tax Court’s decision that the 5% bonus was a dividend because it “looked” like a dividend. The Seventh Circuit pointed out that dividends are normally a fixed dollar amount and do not fluctuate as a percentage of company earnings.
The opinion also criticized the Tax Court for failing to look at the risk associated with the compensation packages of the companies it compared to Menard Inc., and for failing to consider severance agreements, perks and other benefits when determining the value of the other packages.
The Seventh Circuit held that the Tax Court committed clear error in reaching its decision and therefore reversed it.