## Facts

- Menard, Inc. was a closely held home-improvement retail chain controlled by its founder and CEO, John R. Menard, Jr.
- For the 1998 tax year, Menard received compensation consisting of a base salary (about $157,000), a profit-sharing bonus (over $3 million), and an additional bonus set at 5% of corporate pretax profits (over $17.5 million).
- Menard, Inc. deducted Menard’s full 1998 compensation as wages under I.R.C. § 162(a)(1).
- The IRS concluded the compensation was excessive and recharacterized most of the profit-based bonus as a non-deductible dividend rather than compensation “purely for services.”
- The Commissioner disallowed the deduction to the extent compensation exceeded roughly $7.1 million, and the Tax Court agreed and sustained the disallowance above that ceiling.
- On appeal, the Seventh Circuit reviewed the Tax Court’s “reasonableness” determination for clear error and focused on whether the Tax Court’s comparative methodology was supportable.

## Issues

1. Whether the Tax Court clearly erred in finding Menard’s 1998 compensation unreasonable under I.R.C. § 162(a)(1) and treating most of the 5%-of-profits bonus as a disguised dividend.
2. Whether comparisons to compensation at large public companies were reliable where the analysis emphasized cash salary and did not account for equity-based compensation.

## Decision

- The Seventh Circuit reversed the Tax Court.
- The court held the Tax Court clearly erred in capping deductible compensation at approximately $7.1 million.
- The court allowed Menard, Inc. to deduct the full amount of Menard’s 1998 compensation, including the 5%-of-pretax-profits bonus, as reasonable compensation under § 162(a)(1).
- The court found the Tax Court’s reliance on incomplete comparables and “arbitrary” assumptions undermined its factfinding.

## Legal Principles

- Under I.R.C. § 162(a)(1), a corporation may deduct compensation only to the extent it is a reasonable allowance for personal services actually rendered; amounts functioning as dividends are not deductible.
- In closely held corporations, the IRS may challenge purported salary as a disguised dividend because shareholders can shift corporate earnings into deductible compensation.
- Reasonableness analysis must evaluate the economic reality of the compensation arrangement, including the executive’s role, workload, and the degree to which compensation is contingent on performance.
- Comparability evidence is unreliable if it fails to consider total compensation (including equity-based pay) and differences between private, closely held firms and large public companies.
- A profit-based bonus set by an ex ante formula may constitute bona fide compensation, even for a controlling shareholder, when tied to profitability and reflective of services and risk.

## Conclusion

The Seventh Circuit held that the Tax Court’s determination of excessive compensation rested on flawed and incomplete comparisons and unsupported assumptions, and it permitted Menard, Inc. to deduct the CEO’s full profit-based compensation as reasonable under I.R.C. § 162(a)(1) rather than treating it as a disguised dividend.


Menard, Inc. v. Commissioner of Internal Revenue, 560 F.3d 620 (7th Cir. 2009)