T.C. Memo. 2005-3
UNITED STATES TAX COURT
MENARD, INC., Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent
JOHN R. MENARD, Petitioner v.
COMMISSIONER OF INTERNAL REVENUE, Respondent*
Docket Nos. 673-02, 674-02. Filed January 6, 2005.
Robert E. Dallman, Vincent J. Beres, and Robert J. Misey,
Jr., for petitioners.
Christa A. Gruber, J. Paul Knap, and Michael Calabrese, for
respondent.
*
This opinion supplements our previously filed opinion in
Menard, Inc. v. Commissioner, T.C. Memo. 2004-207.
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SUPPLEMENTAL MEMORANDUM OPINION
MARVEL, Judge: On October 14, 2004, we received and filed,
pursuant to Rule 161,1 petitioners’ motion for reconsideration of
our Memorandum Opinion in Menard, Inc. v. Commissioner, T.C.
Memo. 2004-207 (Menard I). Petitioners’ motion for
reconsideration requests that we reconsider two parts of Menard
I:
(1) Our conclusion that John R. Menard’s (Mr. Menard)
compensation for the taxable year ended (TYE) 1998 was not paid
by Menard, Inc. (Menards), purely for Mr. Menard’s services;
(2) our ruling that part of Exhibit 17-J, summarizing the
compensation of Menards’s officers for years before TYE 1991, is
not admissible.
With respect to (1), petitioners contend that we
misinterpreted the opinion of the Court of Appeals for the
Seventh Circuit in Exacto Spring Corp. v. Commissioner, 196 F.3d
833 (7th Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo.
1998-220,2 in deciding whether the compensation paid to Mr.
1
All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code in effect at all relevant times.
2
This case is appealable, barring a stipulation to the
contrary, to the Court of Appeals for the Seventh Circuit. We
are obligated by Golsen v. Commissioner, 54 T.C. 742 (1970),
affd. 445 F.2d 985 (10th Cir. 1971), to apply the independent
investor test articulated by the Court of Appeals in Exacto
(continued...)
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Menard during TYE 1998 was purely for services, as required by
section 162 and section 1.162-7(a), Income Tax Regs. Petitioners
argue that Exacto Spring Corp. eliminated the multifactor test
not only for testing whether the compensation was reasonable but
also for testing whether the compensation was paid purely for
services and that it substituted a bad faith standard for
determining whether compensation was paid purely for services.
With respect to (2), petitioners contend that all of Exhibit
17-J is relevant and that we made factual findings inconsistent
with our ruling excluding information in Exhibit 17-J dealing
with years before TYE 1991.3 Petitioners allege that we must
have relied on the excluded part of Exhibit 17-J to find certain
facts and that we should revisit our ruling to correct the
mistake.
This Supplemental Memorandum Opinion rejects petitioner’s
contentions for the reasons set forth below.
Background
We adopt the findings of fact in Menard I. For convenience
and clarity, we repeat below the previously found facts necessary
2
(...continued)
Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), revg.
Heitz v. Commissioner, T.C. Memo. 1998-220.
3
Our ruling with respect to Exhibit 17-J is set forth in n.4
of Menard I.
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for the disposition of this motion, and we supplement those
findings with additional facts as appropriate.
Menards is an accrual basis taxpayer and has a fiscal year
ending January 31 for tax and financial reporting purposes.
Menards timely filed Form 1120, U.S. Corporation Income Tax
Return, for TYE 1998 on which it reported $3.42 billion of gross
revenue and $315,326,485 of taxable income.
Menards was incorporated in 1962 in Wisconsin. Since its
incorporation, Menards has been primarily engaged in the retail
sale of hardware, building supplies, paint, garden equipment, and
similar items. Menards has approximately 160 stores in nine
Midwestern States and is one of the nation’s top retail home
improvement chains, third only to Home Depot and Lowe’s.
During TYE 1998, Mr. Menard, the controlling shareholder of
Menards, served as its president and chief executive officer
(CEO). Mr. Menard’s compensation for TYE 1998 consisted of the
following:
Item Amount
Base salary
(regular weekly payroll) $62,400
Base salary
(paid in December) 95,100
5-percent bonus 17,467,800
Instant Profit Sharing 3,017,100
Christmas gift bond 185
Total 20,642,585
By comparison, the CEOs of Menards’s two closest competitors
received compensation in TYE 1998 as follows:
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Company Compensation
Home Depot $2,841,307
Lowe’s 6,054,977
For TYE 1998, both Home Depot and Lowe’s had substantially
greater gross revenue, revenue growth, and net income than
Menards, but Menards had the highest return on equity and return
on assets of the three companies.
After applying the independent investor test established by
the Court of Appeals for the Seventh Circuit in Exacto Spring
Corp. v. Commissioner, supra, and after considering evidence of
CEO compensation paid by comparable companies as required by
section 1.162-7(b)(3), Income Tax Regs., we concluded that
Menards’s rate of return on equity was sufficient to create a
rebuttable presumption that Mr. Menard’s compensation for TYE
1998 was reasonable in amount but that the presumption of
reasonableness was rebutted by evidence drawn from comparable
companies that Mr. Menard’s compensation was not reasonable.
After evaluating the evidence, we held that Mr. Menard’s salary
for TYE 1998 was reasonable to the extent of $7,066,912 and
allowed Menards a deduction for that amount.
As an alternative basis for our decision, we decided whether
Mr. Menard’s compensation was payment purely for services
rendered or was instead a disguised dividend. In Exacto Spring
Corp. v. Commissioner, supra at 835, the Court of Appeals for the
Seventh Circuit stated that the “primary purpose of section
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162(a)(1)” is to prevent corporations from disguising dividends
as salary. The Court of Appeals explained that, in addition to
satisfying the independent investor test, for compensation to
qualify as a deductible business expense, the compensation must
be “a bona fide expense”. Id. at 839. The Court of Appeals
described as “material” to this inquiry any evidence showing that
“the company did not in fact intend to pay * * * [the CEO] that
amount as salary, that * * * [the CEO’s] salary really did
include a concealed dividend though it need not have.” Id.
A taxpayer’s intent with respect to the payment of
compensation is a question of fact that must be decided on the
basis of the facts and circumstances. E.g., Paula Constr. Co. v.
Commissioner, 58 T.C. 1055, 1059 (1972), affd. without published
opinion 474 F.2d 1345 (5th Cir. 1973). After reviewing the
relevant facts and circumstances, we concluded that a portion of
Mr. Menard’s salary (the amount in excess of $7,066,912) was not
paid purely for services. In support of our conclusion, we
emphasized several facts. Menards, a closely held corporation,
had never paid a dividend. Menards’s board of directors awarded
Mr. Menard a bonus equal to 5 percent of Menards’s net income
before taxes without making any effort to evaluate whether the
bonus, combined with other components of Mr. Menard’s
compensation, would result in the payment of excessive and
unreasonable compensation. The 5-percent bonus was paid pursuant
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to a formula and was subject to a reimbursement agreement that
required Mr. Menard to reimburse Menards if any portion of the
bonus was disallowed as a deduction. For TYE 1998, the formula
resulted in a bonus that, when added to Mr. Menard’s other
compensation, substantially exceeded the compensation paid to
CEOs in comparable companies.
Petitioners timely filed a motion for reconsideration of our
opinion. In the motion, petitioners (1) challenged our
evidentiary ruling excluding, as irrelevant, the portion of
Exhibit 17-J that summarized Menards’s officer compensation for
taxable years ended before 1991 and (2) challenged our
application of the “purely for services” prong of the section 162
test for the deductibility of compensation. In support of their
motion, petitioners argued, with respect to Exhibit 17-J, that
“other tax years may be relevant to the years in issue by showing
a pattern of behavior.” With respect to the “purely for
services” prong of the section 162 test, petitioners argued that
the holding of the Court of Appeals for the Seventh Circuit
“requires a finding of bad faith by the taxpayer and there has
been no bad faith in this case.”
Discussion
I. Admissibility of Excluded Portion of Exhibit 17-J
Petitioners argue that information regarding Menards’s
officer compensation for taxable years ended before 1991 may be
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relevant as part of a “continuing pattern of activity”, but they
do not explain how the information has any relevance to the two-
prong test for evaluating the deductibility of compensation under
section 162.
The Court of Appeals for the Seventh Circuit in Exacto
Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), has
made it abundantly clear that we must use the independent
investor test to ascertain whether a CEO’s compensation is
reasonable in the first instance. Under the independent investor
test, if a hypothetical independent investor would consider the
rate of return on his investment in the taxpayer corporation “a
far higher return than * * * [he] had any reason to expect”, the
compensation paid to the corporation’s CEO is presumptively
reasonable. Id. at 839. That presumption may be rebutted,
however, if an extraordinary event was responsible for the
company’s profitability or if the executive’s position was merely
titular and his job was performed by someone else. Id. In
Menard I, we concluded that the presumption could also be
rebutted by evidence that comparable publicly traded corporations
paid substantially less compensation to their CEOs than the
amount paid by a closely held corporation, and we held that the
presumption of reasonableness that attached to Mr. Menard’s TYE
1998 compensation had been rebutted by evidence that his
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compensation greatly exceeded the compensation paid by Menards’s
chief competitors to their CEOs.
As respondent points out in his response to petitioners’
motion, petitioners make no attempt to explain why evidence of
Mr. Menard’s compensation for taxable years ended before 1991 has
any relevance to our analysis under the independent investor test
established in Exacto Spring Corp. The independent investor test
focuses on the rate of return on equity for the year the
compensation is paid. The presumption of reasonableness created
by a qualifying rate of return is rebutted either by evidence
that something other than the CEO’s services generated or
contributed to that year’s rate of return or by evidence that the
marketplace considered the CEO’s compensation for that year to be
unreasonable. Petitioners have failed to explain how evidence of
Mr. Menard’s compensation in taxable years ended before 1991 is
relevant to any aspect of the independent investor test.
Petitioners also failed to present any argument regarding why
this evidence is relevant to the “purely for services” prong of
the section 162 test for deducting compensation.
The burden of demonstrating an exhibit’s relevance is on the
party seeking its admission. Dowling v. United States, 493 U.S.
342 (1990). Moreover, a court has broad discretion to determine
the admissibility of evidence based on remoteness in time. Keyes
v. School Dist. No. 1, 521 F.2d 465, 473 (10th Cir. 1975). The
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parties stipulated that compensation information for TYE January
31, 1991, to January 31, 1998, was admissible, and, in accordance
with the parties’ stipulation, we admitted that part of Exhibit
17-J containing compensation information for those years.
Respondent points out that the issue is not whether historical
compensation information is or might be relevant; the issue is
how much historical compensation information is admissible.
Petitioners have not shown that the ruling excluding that part of
Exhibit 17-J containing compensation information for taxable
years ended before January 31, 1991, is an abuse of our
discretion.
In support of their argument, petitioners contend that we
relied in Menard I on the unadmitted part of Exhibit 17-J. In
their motion, petitioners focus on two factual statements in
Menard I. The first is that Mr. Menard has received an annual
bonus since 1973, slip op. at 12, and the second is that the 5-
percent bonus generally increased each year, slip op. at 63.
Petitioners link the two statements together and claim that the
Court must have relied on the unadmitted part of Exhibit 17-J to
make them. Petitioners’ claim is inaccurate. Our statement that
Mr. Menard has received an annual bonus since 1973 is supported
by Exhibit 16-J, by the uncontroverted testimony of Al Pitterle,
and by paragraph 44 of the stipulation of facts. Our statement
that the 5-percent bonus “generally increased each year” is
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supported by the admitted part of Exhibit 17-J, which indicated
that Mr. Menard’s compensation and his 5-percent bonus generally
increased each year from TYE January 31, 1991, through January
31, 1998.
Because petitioners have failed to demonstrate (1) that
compensation information for taxable years ended before January
31, 1991, is relevant and (2) that we relied on the unadmitted
portion of Exhibit 17-J contrary to our ruling, we reject
petitioners’ arguments with respect to Exhibit 17-J.
II. Bad Faith
Petitioners’ argument that Exacto Spring Corp. imposes a
“bad faith” requirement for determining whether compensation is a
disguised dividend is derived entirely from a single statement in
that opinion:
The fact that * * * [the president/shareholder’s salary
at issue] was approved by the other owners of the
corporation, who had no incentive to disguise a
dividend as salary, goes far to rebut any inference of
bad faith here, which in any event the Tax Court did
not draw and the government does not ask us to draw.
Exacto Spring Corp. v. Commissioner, 196 F.3d at 839.
Petitioners conclude from the above-quoted statement that the
Court of Appeals for the Seventh Circuit rejected the multifactor
test for both prongs of the section 162 compensation test and
that the Court of Appeals now requires a showing of bad faith
before we can conclude that compensation was not paid purely for
services.
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We reject petitioners’ argument. We cannot discern any
intention on the part of the Court of Appeals to incorporate a
bad faith requirement into the analysis of whether compensation
is paid purely for services. The Court of Appeals in Exacto
Spring Corp. referenced the two-prong test under section 162 and
stated that deductible compensation under section 162 must be
both reasonable in amount and a payment purely for services. Id.
at 839. In addressing the hypothetical case of a CEO who
rendered no services to his company yet received a substantial
salary, the Court of Appeals stated as follows:
The multi-factor test would not prevent the Tax Court
from allowing a deduction in such a case even though
the corporation obviously was seeking to reduce its
taxable income by disguising earnings as salary. The
court would not allow the deduction, but not because of
anything in the multi-factor test; rather because it
would be apparent that the payment to the employee was
not in fact for his services to the company. Treas.
Reg. §1.162-7(a); * * *.
Id. at 835.
The Court of Appeals did not reject section 1.162-7, Income Tax
Regs. Instead, as evidenced by the above quotation, the Court of
Appeals cites and relies on it for the proposition that
compensation that is not paid purely for services is not
deductible under section 162.
Section 1.162-7(b)(1), Income Tax Regs., speaks specifically
to the “purely for services” prong of the test under section 162.
It states as follows:
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Any amount paid in the form of compensation, but not in
fact as the purchase price of services, is not
deductible. An ostensible salary paid by a corporation
may be a distribution of a dividend on stock. This is
likely to occur in the case of a corporation having few
shareholders, practically all of whom draw salaries.
If in such a case the salaries are in excess of those
ordinarily paid for similar services and the excessive
payments correspond or bear a close relationship to the
stockholdings of the officers or employees, it would
seem likely that the salaries are not paid wholly for
services rendered, but that the excessive payments are
a distribution of earnings upon the stock. * * *
As respondent points out, there is nothing in Exacto Spring Corp.
to indicate that the Court of Appeals now requires a finding of
bad faith to support a conclusion that some part of an
executive’s salary is not purely for services or that the Court
of Appeals has rejected section 1.162-7(b)(1), Income Tax Regs.
(fact that salaries are higher than those ordinarily paid for
similar services is evidence that the salaries are probably not
paid solely for services rendered).
Payments to employee/shareholders of closely held
corporations merit strict scrutiny. Exacto Spring Corp. v.
Commissioner, 196 F.3d at 838; Dexsil Corp. v. Commissioner, 147
F.3d 96 (2d Cir. 1998), remanding T.C. Memo. 1995-135; sec.
1.162-7(b)(1), Income Tax Regs. Mr. Menard owned directly 100
percent of the voting stock and 56 percent of the nonvoting stock
of Menards. The only other shareholders were primarily members
of his family or trusts established for the benefit of Mr. Menard
and family members. The majority of Menards’s board of directors
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in TYE 1998 were family members. From its incorporation in 1973
through and including TYE 1998, Menards had never paid a
dividend. Petitioners have failed to convince us that a finding
of bad faith is required before we can decide that a portion of
Mr. Menard’s compensation was not paid purely for his services as
CEO.
III. Conclusion
For the above-described reasons, we shall deny petitioners’
motion for reconsideration.
An appropriate order
denying petitioners’ motion
for reconsideration will be
issued.