February 10, 2010

CEO Compensation: What's Reasonable?

By Nicholas Sher,

CEO Compensation: What's Reasonable? Tax & Business

Many times when companies are being examined by the IRS, the agent will be required to review compensation to determine its reasonableness. The agents generally use employment experts who compare the compensation of the company under examination with industry standards. Based on this comparison, the agents and their supervisors will evaluate the compensation and decide if it will be fully deductible. Since industry standards have historically been utilized to make these comparisons, taxpayers subject to compensation limitations were at a disadvantage to argue a potential disallowance.

In 2009, the Court of Appeals made an important decision, in the case ofMenard, Inc. v. Commissioner, regarding the use of industry standards and potential compensation adjustments. This decision provides some welcome guidance for companies being challenged under a similar situation. A summary of the facts and final decision follow.

In 1998 John Menard was the chief executive officer of Menard, Inc., which at the time, was the third largest retail home improvement chain in the United States. John Menard was a “workaholic” who built the company into a great success. He owned all of the voting shares in the corporation and more than half the nonvoting shares. For his hard work, in 1998 he received a compensation package that included a salary of $157,500, profit-sharing bonus of $3,017,100, and a 5% bonus of $17,467,800. The total 1998 compensation package exceeded $20 million.

The Internal Revenue Service, in its review of the Company, decided not to allow the 5% bonus deduction. A United States Tax Court decided to rule in favor of the IRS ruling that the bonus was excessive compensation based on compensation of other CEO’s in comparable businesses. The Tax Court used the compensation packages of the chief executive officer of Home Depot and Lowe’s as comparison. The Tax Court ruled that any compensation greater than $7.1 million was excessive and not to be allowed as a deduction. The $7.1 million figure was determined by the Tax Court using a random formula which was based on Menard’s performance and compensation compared to his counterparts at Home Depot and Lowe’s.

On March 10, 2009 the U.S Court of Appeals for the Seventh Circuit decided to reverse the decision of the Tax Court inMenard, Inc. v. Commissioner. The Appeals Court decision states, “We conclude that in ruling that Menard’s compensation was excessive in 1998, the Tax Court committed clear error, and its decision is therefore reversed.” It also states that the $7.1 million dollar figure determined by the Tax Court “was an arbitrary adjustment.” The Appeals Court ruled that “for compensation purposes, the shareholder-employee should be treated like all other employees.” This directly contradicted the Tax Court as its opinion stated that because Mr. Menard owns the company he has all the incentive he needs to work. Essentially compensation is a function of performance. John Menard’s 5% bonus was based on the performance of the company. The court in its decision also noted that John worked extraordinarily hard and did the work that other executives delegated to staff. Had the Company made no profit in 1998, Menard’s compensation would have only been his salary. In the end the Appeals Court ruled that John Menard’s entire compensation in 1998 is allowable as a deduction for Menard, Inc.

This case and fact pattern should be considered when attempting to determine what is reasonable compensation and defending against a claim of unreasonable compensation. To bolster justification for deductions, closely held companies should document executive/owners’ performance of services and provide for an employment agreement.

Should your Company be under current examination and excessive compensation is being challenged, reference to this case should be considered.

If you have any questions pertaining to this article, please Nicholas Sher at 212.981.3121 or via email at[email protected].

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