The opinion
T.C. Memo. 2004-207
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 September 16, 2004.
MI is an accrual basis taxpayer with a fiscal year
ending January 31. S is a cash basis taxpayer who was
the president, CEO, and 89-percent shareholder of MI
during MI’s TYE 1998. S was also the sole shareholder
and president of TMI, a cash basis S corporation. MI
and TMI have never held ownership interests in each
other.
For TYE 1998, MI paid S compensation of
$20,642,485. S’s total compensation included an annual
bonus equal to 5 percent of MI’s net income before
taxes, subject to a reimbursement agreement, which
required that S repay to MI any amount of S’s
compensation disallowed by R as a deduction. MI has
never paid dividends to its shareholders.
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MI paid certain of TMI’s expenses relating to
TMI’s operation of Indianapolis-style race cars from
Feb. 1, 1997, to Jan. 31, 1999 (the TMI expenses), but
had no written agreement with TMI regarding the payment
and/or reimbursement of the TMI expenses. For TYE 1998
and calendar year 1998, the TMI expenses that MI paid
were $6,563,548 and $5,703,251, respectively.
During 1997 and 1998, when S attended the Indy 500
and the other Indy Racing League events, S spent time
talking with MI’s vendors, employees, and customers.
When MI staged grand openings for new stores, TMI
participated by sending drivers and providing an Indy
car for display. MI also worked the TMI connection
into store promotional materials and sales incentives
for employees.
S regularly made loans of his compensation to MI.
The loans were payable on demand. In TYE 1998, MI
capitalized accrued interest on the loans in the amount
of $639,302 and claimed the full amount as a
depreciation deduction. On Jan. 29, 1999, MI issued a
check to S for the interest. S reported the interest
income on his 1999 income tax return.
R determined that MI’s deduction claimed for S’s
compensation was “unreasonable and excessive” to the
extent of $19,261,609; the TMI expenses were not
ordinary and necessary business expenses of MI and,
therefore, not deductible; MI’s payment of the TMI
expenses was a constructive dividend to S; S
constructively received interest income that accrued in
1998 on his loans to MI; and MI and S were liable for
sec. 6662(a), I.R.C., accuracy-related penalties for
negligence or disregard of rules or regulations with
respect to the TMI expenses deduction, constructive
dividend, and constructive receipt of interest income.
1. Held: Although the rate of return on
investment generated by MI for the year at issue
satisfied the independent investor test as articulated
in Exacto Spring Corp. v. Commissioner, 196 F.3d 833
(7th Cir. 1999), revg. and remanding T.C. Memo. 1998-
220, so that a presumption of reasonableness attached
to S’s compensation, sec. 1.162-7(b)(3), Income Tax
Regs., provides that reasonable compensation “is only
such amount as would ordinarily be paid for like
services by like enterprises under like circumstances”
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and requires that we consider whether the presumption
of reasonableness is rebutted by evidence that S’s
compensation greatly exceeded the compensation of CEOs
in comparable publicly traded companies. Held,
further, when compared to the compensation of CEOs of
the comparison group companies, the amount of S’s
compensation was reasonable to the extent of
$7,066,912.
Held, further, alternatively, the language in the
notice of deficiency was sufficient to permit
respondent to argue a portion of S’s compensation was
not paid for services rendered and was a disguised
dividend. Held, further, petitioners were not
surprised or prejudiced by respondent’s disguised
dividend argument. Held, further, S’s compensation was
not paid entirely for personal services rendered and
contained a disguised dividend to the extent that it
exceeded $7,066,912.
2. Held, further, MI did not pay TMI’s expenses
pursuant to an oral sponsorship agreement. Held,
further, to the extent the TMI expenses were reasonable
in amount, MI’s primary motive for paying the TMI
expenses was to promote MI’s business, and the TMI
expenses were ordinary and necessary in the furtherance
or promotion of MI’s business, entitling MI to a
deduction under sec. 162(a), I.R.C.
3. Held, further, to the extent MI may not deduct
the TMI expenses as ordinary and necessary business
expenses, the TMI expenses are a constructive dividend
to S, because, as TMI’s president and sole shareholder,
S exercised indirect control over the payments; the
payments lacked a legitimate business justification;
and S directly benefitted from the payments.
4. Held, further, in 1998, S constructively
received the interest that accrued during MI’s TYE 1998
on his loans to MI because MI set apart the accrued
interest, S could have demanded payment of the interest
at any time, and MI placed no substantial restrictions
or limitations on S’s receipt of the interest.
5. Held, further, MI and S failed to demonstrate
that their accountant had necessary and accurate
information for preparing their returns and, therefore,
are liable for sec. 6662(a), I.R.C., accuracy-related
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penalties for negligence or disregard of rules or
regulations as follows: MI is liable with respect to
the TMI expenses deduction as disallowed, and S is
liable with respect to the excess TMI expenses
constructive dividend and the constructively received
interest income.
Robert E. Dallman, Vincent J. Beres, and Robert J. Misey,
Jr., for petitioners.
Christa A. Gruber, J. Paul Knap, and Michael Calabrese, for
respondent.
MEMORANDUM FINDINGS OF FACT AND OPINION
MARVEL, Judge: These cases were consolidated upon motion of
the parties for purposes of trial, briefing, and opinion.
Respondent determined deficiencies and section 6662(a)1 accuracy-
related penalties with respect to petitioners’ income tax and, by
amendment to answer, increased those deficiencies as follows:
Menard, Inc., docket No. 673-02
Accuracy-related penalty
TYE Jan. 31 Deficiency sec. 6662(a)
1998 $8,966,233 $430,414
1
All section references are to the Internal Revenue Code in
effect for the years in issue, and all Rule references are to the
Tax Court Rules of Practice and Procedure. Monetary amounts are
rounded to the nearest dollar.
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John R. Menard, docket No. 674-02
Accuracy-related penalty
Year Deficiency sec. 6662(a)
1998 $4,909,407 $981,882
At the close of trial, pursuant to Rule 41(b)(1), respondent
moved to amend the pleadings to conform to the evidence in light
of testimony revealing that petitioner Menard, Inc., paid, and
claimed as a deduction, Team Menard, Inc., salaries. We granted
respondent’s motion. On the basis of the Rule 41(b)(1) motion
and concessions of the parties,2 respondent determined
petitioners’ deficiencies and section 6662(a) accuracy-related
penalties as follows:
Accuracy-related penalty
Docket No. Deficiency sec. 6662(a)
673-02 $9,069,126 $460,031
674-02 2,587,000 517,400
2
In the stipulation of facts, the parties agreed that for
petitioner Menard, Inc.’s (Menards), taxable years ending Jan.
31, 1998 (TYE 1998), and Jan. 31, 1999 (TYE 1999), and for
petitioner John R. Menard’s (Mr. Menard) taxable year ending Dec.
31, 1998, Menards paid $4,731,881, $3,791,202, and $3,853,251,
respectively, of Team Menard, Inc.’s (TMI), expenses.
Additionally, in the stipulation of facts, respondent conceded
that to the extent Menards claimed deductions for TMI expenses
that Menards paid during the period from Feb. 1 to Dec. 31, 1997,
those amounts are not constructive dividends to Mr. Menard for
his taxable year ending Dec. 31, 1998.
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After further concessions,3 the issues for decision are:
(1) Whether petitioner Menard, Inc. (Menards), is entitled
to deduct $20,642,485, the total compensation paid to petitioner
John R. Menard (Mr. Menard), or some lesser amount, as officer’s
compensation for the taxable year ending January 31, 1998 (TYE
1998);
(2) whether Menards is entitled to claim deductions under
section 162 of $6,563,548 for the payment of Team Menard, Inc.
(TMI), salaries and expenses during TYE 1998;
(3) whether Menards’s payment of TMI’s salaries and expenses
during the calendar year 1998 of $5,703,251 constituted a
constructive dividend to Mr. Menard for 1998;
(4) whether interest of $639,302 that accrued during 1998 on
loans from Mr. Menard to Menards, but that was paid to and
reported by Mr. Menard in 1999, constituted interest income
constructively received in 1998; and
3
In Menards’s notice of deficiency, respondent determined
that (1) Menards was not entitled to a depreciation deduction of
$20,213 with respect to the grading of land, and (2) Menards was
not entitled to a deduction of $187,218 with respect to legal and
professional fees incurred in the development or improvement of
property. In the stipulation of facts, respondent conceded that
Menards properly capitalized $129,129 of the legal and
professional fees. On brief, petitioner conceded both issues.
Respondent also proposed adjustments to Mr. Menard’s
itemized deductions. The parties agree that this issue is
computational.
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(5) whether Menards and Mr. Menard are liable for accuracy-
related penalties under section 6662(a) for negligence or
disregard of rules or regulations.
FINDINGS OF FACT
Some of the facts have been stipulated. We incorporate the
stipulated facts into our findings by this reference.4 Both
4
In the stipulation of facts, petitioners objected on the
basis of relevance to stipulations concerning Menards’s officers’
compensation for TYE 1999, TMI’s involvement in the NASCAR
Craftsman Truck Series in 2000, and Menards’s sponsorship of a
Championship Auto Racing Team (CART) driver in 1999. We sustain
petitioners’ objections.
In addition, in the stipulation of facts, both parties
objected to the admission of several accompanying exhibits on the
basis of relevance. Petitioners objected to the admission of
Exhibit 36-J, TMI’s 1999 income tax return; Exhibits 61-J through
64-J, documents pertaining to Menards’s revolving credit program;
Exhibit 65-J, a 1995-96 Indy Racing League season associate-
sponsorship agreement between TMI and Green Tree Financial Corp.;
and Exhibit 66-J, documents pertaining to Menards’s business
relationship with Stanley Tools, including mention of Stanley
Tools as a TMI associate sponsor. We sustain petitioners’
objections.
Respondent objected on the basis of relevance to the
admission of Exhibit 17-J, to the extent that it analyzes
Menards’s officer compensation in years before 1991; Exhibit 75-
J, drawings currently used to promote Menards’s Race to Savings
sale; Exhibits 78-J and 79-J, 1993 and 1997 Internal Revenue
Service Information Document Requests addressed to Menards;
Exhibits 80-J and 81-J, Income Tax Examination Changes for
Menards’s TYE 1991, TYE 1992, and TYE 1994 through TYE 1997;
Exhibits 83-J through 92-J, independent auditor’s reports for
Menards’s TYE 1972 through TYE 1991; Exhibit 106-J, to the extent
it includes diagrams of Menards’s store prototypes other than
Prototype III; Exhibit 107-J, a memo to Glidden from Menards;
Exhibits 123-J through 127-J and 129-J, magazine and online news
articles about racing, printed in 1999, 2000, and 2001; and
Exhibit 128-J, a complaint filed in an unrelated case in 2000 for
(continued...)
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Menards’s principal place of business and Mr. Menard’s residence
were located in Eau Claire, Wisconsin, when the petitions in
these consolidated cases (hereinafter this case) were filed.
I. Menards
Menards is an accrual basis taxpayer and has a fiscal year
ending January 31 for tax and financial reporting purposes. On
October 15, 1998, Menards timely filed Form 1120, U.S.
Corporation Income Tax Return, for TYE 1998 and reported
$315,326,485 of taxable income.
A. Menards’s Business In General
Menards was incorporated on February 2, 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. In TYE 1998, Menards’s revenue totaled $3.42 billion.
4
(...continued)
breach of a CART sponsorship agreement. We overrule respondent’s
objections to Exhibits 126-J and 127-J, and we sustain
respondent’s remaining objections.
Finally, in the stipulation of facts, respondent objected on
the basis of hearsay to Exhibit 120-J, the first page of an
alphabetical list of auto racing sponsors, printed in 1996, and
Exhibit 122-J, a Web site posting by a team called Davis & Weight
Motorsports seeking primary and associate sponsors for the 2002
NASCAR Winston Cup Series season. We sustain respondent’s
objections. See Fed. R. Evid. 802. We also note that these
documents are not relevant to this case.
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B. Menards’s Corporate Structure5
Menards has three major divisions: Operations,
manufacturing, and corporate. All department managers, plant
managers, and supervisors report to Mr. Menard and his division
managers.
1. Operations
The operations division controls Menards’s retail stores.
Mr. Menard’s brother, Lawrence Menard (L. Menard), serves as
operations manager and oversees all aspects of the stores’
operations with respect to personnel. The merchandising
department, an offshoot of the operations division, handles the
stores’ merchandising needs. Edward S. Archibald, senior
merchandising manager, oversees the purchasing, merchandising,
and marketing of all items for resale at Menards. Mr.
Archibald’s involvement in marketing includes the use of print
and broadcast media for store promotions.
2. Manufacturing
Midwest Manufacturing (Midwest), the manufacturing division,
operated eight manufacturing plants during TYE 1998. Dennis W.
Volbrecht, Midwest’s general manager, oversees all departments
and facilities, supervises the plant managers, and assists in the
design and proposal of products.
5
Unless otherwise noted, Menards’s corporate structure
during TYE 1998 was the same as described herein.
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3. Corporate
The corporate division comprises, among other things, the
accounting, legal, properties, construction, and store-planning
departments. In the accounting department, Robert J. Norquist,
corporate controller, manages all functions of the general ledger
system, including the preparation of monthly financial
statements. Mr. Norquist is also responsible for the fixed asset
system; accounts payable; the payroll systems; tax returns for
sales tax, payroll tax, and excise tax; and the day-to-day
cashflow.
As head of the properties department, Marvin Prochaska is
responsible for the acquisition, development, management, and
disposition of real estate for Menards. Mr. Prochaska is also
responsible for Menards’s construction and store-planning
departments. The construction department provides onsite and
offsite construction management for Menards’s construction
projects, and store planning works with civil engineers to
develop site, structural, architectural, and floor plans.
C. Menards’s Officers and Shareholders
1. Officers
During TYE 1998, Menards’s corporate officers were Mr.
Menard, president and chief executive officer (CEO); Mr.
Prochaska, vice president of real estate; Earl Rasmussen, chief
financial officer and treasurer; and Chris Menard (C. Menard),
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secretary.6 The officers received compensation for TYE 1998 in
the following amounts:
Officer Compensation
Mr. Menard $20,642,485
Mr. Prochaska 121,307
Mr. Rasmussen 55,702
Mr. C. Menard 172,815
2. Shareholders
Since the incorporation of Menards, Mr. Menard has been the
controlling shareholder. During the years at issue, Mr. Menard
owned all of the class A voting stock and approximately 56
percent of the class B nonvoting stock. Mr. Menard’s family
members and trusts named after him and his family members held
the remaining class B shares.7 In all, Mr. Menard owned
approximately 89 percent of Menards’s voting and nonvoting stock.
Menards has never paid dividends to its shareholders.
D. Menards’s Employee Compensation Plan
1. In General
During TYE 1998, Menards provided all employees with health,
401(k), and instant profit-sharing (IPS)8 plans. Other than IPS
6
Chris Menard is Mr. Menard’s son. In addition to his
duties as secretary, Chris Menard ran Menards’s Eau Claire
distribution center.
7
The record does not indicate whether Mr. Menard was a
beneficiary of any shareholder trust.
8
Menards implemented the IPS plan in 1966. The amount that
an employee receives under the plan is a function of the
(continued...)
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and Mr. Menard’s bonus plan discussed, infra, Menards had no
written bonus plan for its officers. However, Menards’s
executives met with Mr. Menard to discuss performance goals and
compensation. Menards regularly paid low base salaries to
executives, supplemented with large bonuses.9
2. Mr. Menard’s Compensation Plan
In addition to the forms of compensation available to all
employees, Menards pays Mr. Menard an annual bonus. Since
1973,10 Mr. Menard has received an annual bonus equal to 5
percent of Menards’s net income before taxes (the 5-percent
bonus). The 5-percent bonus is subject to the following
reimbursement agreement: In the event that the Commissioner
disallows as a deduction any portion of Mr. Menard’s
compensation, Mr. Menard must repay to Menards the entire amount
disallowed.
8
(...continued)
company’s profitability that year and the employee’s tenure with
Menards and ranges from 2.5 percent to 15 percent of the
employee’s salary.
9
For example, in TYE 1998, Lawrence Menard (L. Menard),
operations manager, received a base salary of $45,000 and a bonus
of approximately $180,000.
10
Al Pitterle, Menards’s outside certified public accountant
at the time, originally suggested an annual incentive bonus for
Mr. Menard. On Jan. 15, 1973, Menards’s board of directors,
consisting of Mr. Menard, L. Menard, and Jeffrey E. Smith, agreed
that Mr. Menard’s bonus should reflect his efforts to produce
profits for the company. The board instituted the 5-percent
bonus at another meeting on June 6, 1973.
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In a resolution effective December 20, 1996, Menards’s board
of directors11 decided that, for TYE 1998, Menards would pay Mr.
Menard a salary of $157,500 and the 5-percent bonus. Mr.
Menard’s total compensation in TYE 1998 consisted of the
following items:
Item Amount
Base salary
(regular weekly payroll) $62,400
Base salary
(paid in December) 95,100
5-percent bonus 17,467,800
IPS 3,017,100
Christmas gift bond 185
1
20,642,585
1
This figure contains an unreconciled difference of $100 on
Mr. Menard’s 1997 Form W-2, Wage and Tax Statement.
Mr. Menard’s total compensation constituted 0.6 percent of
Menards’s TYE 1998 gross receipts and 5.16 percent of all other
employees’ wages.
II. Comparable Companies and Rate of Return on Investment
A. Compensation Paid by Comparable Publicly Traded
Companies
For purposes of comparing Mr. Menard’s compensation to CEO
compensation of publicly traded companies, the comparison group
consists of the following five publicly traded companies: Home
11
Menards’s board of directors at this time consisted of Mr.
Menard, L. Menard, and Earl Rasmussen.
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Depot, Kohl’s, Lowe’s, Staples, and Target. For services
performed in TYE 1998, the comparison group companies paid
compensation to their CEOs as follows:
Company Compensation
Home Depot $2,841,307
Kohl’s 5,110,578
Lowe’s 6,054,977
Staples 6,868,747
Target 10,479,528
B. Rate of Return on Investment
For TYE 1998, the comparison group companies’ and Menards’s
rates of return on equity12 were as follows:
Company Return on Equity
Menards 18.8%
Home Depot 16.1
Kohl’s 14.8
Lowe’s 13.7
Staples 15.3
Target 16.7
III. Mr. Menard
Mr. Menard is a cash basis taxpayer with a taxable year
ending December 31. Between March 30 and April 15, 1999, Mr.
Menard timely filed Form 1040, U.S. Individual Income Tax Return,
for 1998.
A. Mr. Menard’s Duties and Responsibilities at Menards
Since he founded the company, Mr. Menard has been involved
in Menards’s daily business affairs. During TYE 1998, Mr. Menard
12
As calculated herein, return on equity equals net income
divided by shareholders’ equity and multiplied by 100 percent.
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worked 6 or 7 days a week for 12 to 16 hours a day and
communicated with Menards’s executives on a regular basis.
As CEO of Menards, Mr. Menard was responsible for all three
of Menards’s major divisions. Mr. Menard’s direct involvement
with the operations division included discussions with L. Menard
about store issues, visits to Menards stores, review of customer
complaints, and examination of operations division employees’
reports detailing their store visit findings.
With respect to Midwest, Mr. Menard reviewed financial
statements and project plans and granted final approval for any
purchases of new equipment, additions of new products, changes to
existing products, additions of new Midwest facilities, and
changes to existing Midwest facilities. Mr. Menard worked
directly with Mr. Volbrecht on these matters.
In connection with the corporate division, Mr. Menard worked
with Mr. Prochaska on real estate acquisitions, dispositions, and
leasing. Mr. Menard also assisted in the development of the
Menards prototype stores and plans for the construction of a
second distribution center.
B. Mr. Menard’s Loans to Menards
As part of his personal investment strategy, Mr. Menard made
loans of his compensation to Menards during TYE 1998 and 1999.
The loans were evidenced by promissory notes that were payable on
demand and bore interest at the short-term applicable Federal
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rate. According to Menards’s books and records, the shareholder
loans account balances at the close of TYE 1998 and TYE 1999 were
$21,057,954 and $31,217,954, respectively. Menards’s financial
statements indicated that Menards possessed cash and marketable
securities at the close of TYE 1998 and TYE 1999 of $138,550,434
and $242,932,229, respectively.
In TYE 1998, Menards capitalized accrued interest of
$639,302 on shareholder loans and claimed the full amount as a
deduction on its tax return. On January 29, 1999, Menards issued
to Mr. Menard a check for the interest. On his 1999 tax return,
Mr. Menard reported that amount as interest income from Menards
for loans outstanding as of December 31, 1998. Mr. Menard did
not report any interest income from loans to Menards on his 1998
tax return.
IV. TMI
TMI is a cash basis taxpayer and has a fiscal year ending
December 31 for tax and financial reporting purposes. At all
relevant times, TMI was an S corporation, owned entirely by Mr.
Menard. Menards and TMI have never held ownership interests in
each other.
A. TMI’s Business and Management
Incorporated in 1992, TMI is in the business of engineering
and racing Indianapolis-style race cars (Indy cars). From 1992
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until 1995, TMI was active in the United States Auto Club (USAC)
and then moved to the Indy Racing League (IRL)13 during 1996.
Although, as TMI’s president, Mr. Menard made most of the
major business decisions, he did not run the day-to-day
operations of the company. With the exception of the latter part
of 1998,14 Larry Curry ran TMI’s daily operations. Mr. Norquist,
Menards’s corporate controller, managed TMI’s accounting
functions.
B. TMI’s Racing Activities in 1997 and 1998
1. Race Participation
During the 1997 and 1998 IRL racing seasons, TMI
participated in 8 and 11 events, respectively, including both
Indianapolis 500 (Indy 500) races. Tony Stewart and Robbie Buhl
were TMI’s principal drivers for those two seasons. Although TMI
never won the Indy 500, Tony Stewart was the 1997 IRL champion.
For the 1997 IRL racing season, Tony Stewart drove car No.
2, referred to as “Glidden/Menard/Special”, and Robbie Buhl drove
car No. 3, referred to as “Quaker State/Menards/Special” or
“Menard/Quaker State Special”. For the 1998 IRL racing season,
Tony Stewart drove car No. 1, “Glidden/Menard/Special”, and
13
The Indy Racing League (IRL) holds approximately 10 races
each year in the United States. The principal race is the
Indianapolis 500.
14
Tom Knapp ran TMI’s day-to-day operations at the end of
1998.
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Robbie Buhl drove car No. 3, “Johns Manville/Menard/Special”.
During both IRL seasons, the race cars, driver uniforms, and Indy
promotional materials exhibited Menards’s logo, among the logos
of several sponsors.
2. The Sponsors
In addition to Menards’s involvement with TMI,15 several
other companies sponsored TMI’s race cars during the 1997 and
1998 IRL seasons. Some of TMI’s written sponsorship agreements
were part of larger business arrangements that Menards had with
its suppliers. According to TMI’s sponsorship income reports,
TMI received sponsorship fees from eight sponsors during both the
199716 and 199817 IRL seasons. Besides the sponsors listed on the
15
This reference with respect to Menards does not establish
that a legal sponsorship agreement existed between Menards and
TMI.
16
For the 1997 IRL season, TMI’s sponsorship income report
listed Campbell Hausfeld, First Brands, Gilmore Enterprises,
Greentree, Quaker State, Ruan, Ryobi, and Stanley Tools as
sponsors. Except for Gilmore Enterprises, Menards had business
relationships with all of these companies. Respectively, the
1997 listed sponsors paid sponsorship fees of $500,000; $250,000;
$100,000; $500,000; $1,480,730; $11,060.49; $375,000; and
$500,000. Glidden was also a sponsor for the 1997 IRL season but
did not pay its $1,800,000 sponsorship fee until February 1998.
TMI’s sponsorship income report for the 1997 IRL season does not
list Menards as a sponsor.
17
For the 1998 IRL season, TMI’s sponsorship income report
listed Campbell Group (Campbell Hausfeld), First Brands, Glidden,
Greentree, Moen, Quaker State, Ryobi, and Stanley Tools as
sponsors. Respectively, the 1998 listed sponsors paid
sponsorship fees of $500,000; $250,000; $2 million; $250,000;
$500,000; $1 million; $125,000; and $650,000. TMI’s sponsorship
(continued...)
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reports, TMI was also sponsored by Glidden, the consumer division
of ICI Paints, North America (ICI), during the 1997 IRL season
and Johns Manville during the 1997 and 1998 seasons.18
For both 1997 and 1998, Glidden was one of TMI’s main
sponsors. Not only was the Glidden name included in the name of
Tony Stewart’s car, the Glidden logo also was prominently
featured on the race car, on Mr. Stewart’s uniform, and in Indy
promotional materials. On occasion, before the races, Glidden
executives, ICI executives, or “other customers from other
divisions” had lunch or dinner with Mr. Menard. Glidden paid
cash sponsorship fees of $1.8 million for 1997 and $2 million for
1998 and offered other financial support estimated to be worth
$550,000, including “clothing for the pit crew, shared food
expense at Indy, as well as over and above promotional support
for the Indy store promotion.”
17
(...continued)
income report for the 1998 IRL season also lists Menards as a
sponsor to the extent of $45,000.
18
Glidden was a TMI sponsor during both the 1997 and 1998
IRL seasons but did not pay for the 1997 sponsorship until 1998.
As a cash basis taxpayer, TMI did not report Glidden’s 1997
sponsorship fee until it was received in 1998. Although Johns
Manville was not listed on the sponsorship income report for
either year, its logo appeared on TMI’s 1997 and 1998 race cars,
and its national accounts manager, John O’Reilly, testified that
Johns Manville sponsored TMI during both seasons. Accordingly,
assuming that Johns Manville was a sponsor during the 1997 and
1998 IRL seasons, excluding Menards, TMI actually had 10 sponsors
during the 1997 IRL season and 9 during the 1998 IRL season.
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In 1997, another main TMI sponsor was Quaker State. Not
only did Quaker State’s name appear in the name of Robbie Buhl’s
car, but Quaker State was the car’s primary sponsor. Quaker
State received prominent logo placement on the race car, pit crew
jackets, and Indy promotional materials. Quaker State paid TMI a
sponsorship fee of approximately $1.5 million.
During 1998, Johns Manville was a major TMI sponsor. In
addition to the Johns Manville reference in the name of Robbie
Buhl’s car, Johns Manville’s logo appeared prominently on the
race car, on Mr. Buhl’s uniform, and in Indy promotional
materials. Other sponsorship benefits included opportunities for
Johns Manville’s customers to meet Mr. Menard, the team, and the
drivers; logo positioning on the driver’s cars within view of the
onboard camera; and use of new Johns Manville products19 on the
race car. Although Johns Manville’s national account manager,
John O’Reilly, testified that Johns Manville paid sponsorship
fees, the record does not reveal the amount paid for either year.
C. Menards, Mr. Menard, and TMI
1. Menards’s General Involvement in Motor Sports
Menards originally became involved in motor sports in 1979.
From 1980 until 1992, the year of TMI’s incorporation, Menards
directly owned, sponsored, and raced cars. Menards was active in
19
Johns Manville sold fiberglass insulation.
- 21 -
the USAC20 and the Championship Auto Racing Team racing divisions
and participated in the Indy 500.21 Mr. Menard viewed motor
sports as a way to garner publicity for the stores, attract
suppliers’ attention, and distinguish Menards from its
competition.22 On the advice of Menards’s attorney, Webster Hart,
over concerns about Menards’s liability in the event of an
injurious racing accident, Mr. Menard formed TMI in order to
shield Menards from potential liability.
2. Mr. Menard’s Participation in Motor Sports
a. Participation as a Driver
Although Mr. Menard has never personally driven Indy cars,
he has participated in motor sports for some time. In the 1980s,
Mr. Menard personally drove cars in the IMSA series and the IS
series and also raced gocarts. Since the formation of TMI in
1992, Mr. Menard has personally participated in gocart racing, IS
series racing, and, in the early 1990s, sports car racing.
b. Indy 500
When TMI participated in the 1997 and 1998 Indy 500 races,
20
Menards participated in the United States Auto Club during
the following years: 1980-82, 1984, 1986-87, and 1989-92.
21
Menards first qualified for the Indy 500 in 1981 and
participated thereafter in 1982, 1984, and 1989-91.
22
Eventually, Home Depot and Lowe’s also became involved in
motor sports.
- 22 -
Mr. Menard attended the time trials and the actual races.23
Typically, Mr. Menard arrived at the racing venue either the day
before or the day of the race. On race day, both before and
after the race, Mr. Menard talked with sponsors, potential
sponsors, vendors, potential vendors, Menards employees, and
Menards customers.24 During the race, Mr. Menard stayed in the
pits with the team.
c. Other IRL Races
For IRL races other than the Indy 500, Mr. Menard usually
arrived on Saturday for the morning practice and stayed through
the race on Sunday. At these events, Mr. Menard was with the
racing team for practice, qualifying, and the race itself but
spent the rest of his time talking with sponsors, vendors, and
Menards employees. On occasion, if the racing venue was located
near a Menards store or a competitor’s store, Mr. Menard would
visit the store. Mr. Menard missed approximately one racing
event in each of 1997 and 1998.
3. Menards’s Relationship With TMI
a. Payment and Deduction of TMI’s Expenses
Menards paid certain of TMI’s expenses relating to TMI’s
23
The Indy 500 time trials and races were held on separate
weekends.
24
Other Menards executives, including L. Menard and Mr.
Archibald, engaged in business-related activities at the Indy
500.
- 23 -
operation of race cars from February 1, 1997, to January 31, 1999
(the TMI expenses), but had no written agreement with TMI
regarding the payment and/or reimbursement of the TMI expenses.
For TYE 1998 and calendar year 1998, Menards paid TMI expenses,
including salaries,25 of $6,563,548 and $5,703,251, respectively.
TMI did not record in its books and records, or report on its tax
return for 1998, any income as received from Menards for
sponsorship fees. Although Menards claimed deductions for the
TMI expenses on its tax returns for TYE 1998 and TYE 1999,26
Menards did not identify the TMI expenses as sponsorship fees or
advertising expenses.
In addition, Menards did not create or maintain separate
accounts in its books and records identifying the TMI expenses as
sponsorship fees or advertising expenses. Instead, Menards
recorded the TMI expenses in 10 different accounts of Menards’s
corporate division according to expense type.27 For example,
Menards recorded amounts spent on car parts under “Repairs
25
For 1997 and 1998, Menards paid TMI employee salaries of
approximately $1,830,000 and $1,850,000, respectively. The two
amounts do not include pension, profit-sharing, or health
insurance costs.
26
TMI did not claim the TMI expenses as deductions on its
tax returns for the relevant periods.
27
The 10 corporate accounts had the following headings:
Repairs Vehicles, Minor Tools, Professional Fees, Travel,
Vehicles and Equipment, Gas and Oil, Advertising, Miscellaneous,
Legal, and Rental.
- 24 -
Vehicles” and fuel under “Gas and Oil”. Only costs directly
related to advertising, such as logos placed on the cars, were
recorded under “Advertising”. This method of accounting for the
TMI expenses was Menards’s approach to accounting for its own
racing expenses prior to TMI’s incorporation.
Menards also owned the racing assets used by TMI and
depreciated them on its books, records, and tax returns. TMI’s
assets consisted only of cash.
b. TMI’s Connection to Menards’s Business
When Menards staged grand openings for new stores, TMI
participated by sending drivers and providing an Indy car for
display. During TYE 1998, Tony Stewart and Robbie Buhl made
appearances at openings and signed autographs. Menards further
implemented the racing theme at store openings with a contest in
which customers could register to win a mini-Indy car.28
Menards also worked the TMI connection into store
promotional materials, particularly with respect to the annual
Race to Savings sale built around the Indy 500 and Memorial Day
weekend. The ads for the Race to Savings sale featured images of
TMI’s Indy cars and logo, as did employees’ T-shirts worn for the
sale. Customers could register to win a replica of the Indy 500
pace car.
28
The mini-Indy car had 3.5 horsepower, a gasoline-powered
engine, and retailed at $700 in 1997.
- 25 -
In addition to sales promotions, Menards used its
relationship with TMI to create sales incentives for employees.
For example, in 1997 and 1998, employees who met the performance
requirements for the Indy 500 contest attended an Indy 500
practice where they toured the garage, the pits, and the track;
had access to the hospitality area; and met with the drivers for
photos and autographs.
V. Preparation of Petitioners’ Tax Returns
Since 1991, Stienessen, Schlegel & Co., LLC (the accounting
firm), has served as Menards’s and TMI’s outside accountant and
Mr. Menard’s personal accountant. Joseph G. Stienessen, the
managing member of the accounting firm, has been a certified
public accountant for approximately 30 years. For the years at
issue, the accounting firm prepared petitioners’ income tax
returns and also prepared TMI’s 1997 and 1998 income tax returns.
VI. Respondent’s Determinations and Petitioners’ Petitions
On October 12, 2001, respondent sent to Menards and Mr.
Menard separate notices of deficiency. In the notice sent to
Menards, respondent determined that (1) Menards’s deduction of
$20,642,485 claimed for Mr. Menard’s compensation was
“unreasonable and excessive”; (2) the TMI expenses were not
ordinary and necessary business expenses of Menards and,
therefore, not deductible; and (3) Menards was liable for a
section 6662(a) accuracy-related penalty for negligence or
- 26 -
disregard of rules or regulations with respect to the TMI
expenses deduction. In Mr. Menard’s notice, respondent
determined that (1) Menards’s payment of the TMI expenses was a
payment to Mr. Menard, or for his benefit, and constituted a
constructive dividend to him; (2) Mr. Menard constructively
received interest income that accrued in 1998 on his loans to
Menards; and (3) Mr. Menard was liable for a section 6662(a)
accuracy-related penalty for negligence or disregard of rules or
regulations with respect to the TMI expenses constructive
dividend and the constructive receipt of interest income.
On January 9, 2002, Menards and Mr. Menard separately filed
timely petitions contesting respondent’s determinations. Mr.
Menard filed an amended petition on February 6, 2003.
OPINION
I. Burden of Proof
Generally, the Commissioner’s determinations are presumed
correct, and the taxpayer bears the burden of proof. Rule
142(a)(1); Welch v. Helvering, 290 U.S. 111, 115 (1933).
Deductions are a matter of legislative grace, and a taxpayer must
clearly demonstrate entitlement to the claimed deductions.
INDOPCO, Inc. v. Commissioner, 503 U.S. 79, 84 (1992). The
Commissioner bears the burden of proof with respect to increases
in deficiencies asserted in an amendment to answer. See Rule
142(a)(1).
- 27 -
Section 7491, which is generally effective for court
proceedings arising in connection with examinations commencing
after July 22, 1998, authorizes the burden of proof to be shifted
to the Commissioner if certain requirements are met. Section
7491(a)(1) provides that “If, in any court proceeding, a taxpayer
introduces credible evidence with respect to any factual issue
relevant to ascertaining the liability of the taxpayer for any
tax imposed by subtitle A or B, the Secretary shall have the
burden of proof with respect to such issue.” However, section
7491(a)(1) applies with respect to a factual issue only if the
requirements of section 7491(a)(2) are satisfied. Section
7491(a)(2) requires that a taxpayer must have complied with all
substantiation requirements, that a taxpayer must have maintained
all records required by title 26 and must have cooperated with
reasonable requests by the Secretary for witnesses, information,
documents, meetings, and interviews, and, if the taxpayer is a
corporation, the taxpayer must satisfy the net worth requirements
of section 7430(c)(4)(A)(ii).
In the instant case, petitioners did not raise the
application of section 7491 with respect to any factual issue
either before or during trial. In a footnote of their reply
brief, petitioners asserted that they had produced credible
evidence with respect to the reasonableness of the amount of the
TMI expenses and that the burden of proof on that issue should
- 28 -
shift to respondent under section 7491. We disagree.
Petitioners have not shown that they satisfied the section
7491(a)(2)(A) and (B) requirements to substantiate any item,
maintain all required records, and cooperate with respondent’s
reasonable requests. Moreover, petitioner’s untimely assertion
in their reply brief has prejudiced respondent’s ability to
present evidence regarding whether petitioners satisfied the
requirements of section 7491(a)(2). See Estate of Aronson v.
Commissioner, T.C. Memo. 2003-189.
For the foregoing reasons, we conclude that section 7491(a)
does not shift the burden of proof to respondent on the issue of
the reasonableness of the TMI expenses.29 Moreover, we note that
we base our findings of fact on the preponderance of the evidence
in the record and not upon any allocation of the burden of proof.
Respondent concedes having the burden of production, pursuant to
section 7491(c) with respect to Mr. Menard’s liability for the
section 6662(a) accuracy-related penalty.30
II. Deductibility of Compensation Paid to Mr. Menard
Section 162(a)(1) provides that a taxpayer may deduct as an
ordinary and necessary business expense “a reasonable allowance
29
Even if sec. 7491(a) operated to shift the burden of proof
to respondent in this case, the record establishes facts
sufficient to support our conclusions regarding the TMI issue
accordingly.
30
Sec. 7491(c) does not place the burden of production on
the Commissioner when the taxpayer is a corporation.
- 29 -
for salaries or other compensation for personal services actually
rendered”. Thus, compensation is deductible only if (1)
reasonable in amount and (2) paid or incurred for services
actually rendered. See sec. 1.162-7(a), Income Tax Regs., which
provides that “The test of deductibility in the case of
compensation payments is whether they are reasonable and are in
fact payments purely for services.” Whether amounts paid as
wages are reasonable compensation for services rendered is a
question of fact to be decided on the basis of the facts and
circumstances of each case. Estate of Wallace v. Commissioner,
95 T.C. 525, 553 (1990), affd. 965 F.2d 1038 (11th Cir. 1992).
Petitioners contend that Menards is entitled to deduct the
full amount of Mr. Menard’s compensation as an ordinary and
necessary business expense under section 162. In contrast,
respondent asserts that $19,261,609 of Mr. Menard’s compensation
is a disguised dividend.
A. Scope of the Notice of Deficiency
According to petitioners, the language in the notice of
deficiency explaining respondent’s determination that a portion
of Mr. Menard’s compensation was “unreasonable and excessive” did
not encompass respondent’s theory that the excess compensation
was a disguised dividend. Petitioners contend that the language
referred only to respondent’s determination that the amount of
Mr. Menard’s compensation was unreasonable. As a result,
- 30 -
petitioners assert, respondent’s disguised dividend theory
constituted a new matter, raised for the first time in
respondent’s trial memorandum, and surprised and prejudiced
petitioners.31
Respondent, on the other hand, contends that the language in
the notice of deficiency, though stated with “brevity”, permitted
respondent to rely on all theories consistent with “the Code
section under which the deficiency * * * [was] determined.”
According to respondent, the phrase “unreasonable and excessive”
clearly implies section 162(a)(1). Respondent points to the
petition’s description of Mr. Menard’s compensation as “an
ordinary and necessary business expenditure” as evidence that
Menards knew the notice implicated section 162(a)(1).
In addition, respondent cites Nor-Cal Adjusters v.
Commissioner, 503 F.2d 359 (9th Cir. 1974), affg. T.C. Memo.
1971-200, in which the taxpayer raised a similar argument. In
Nor-Cal Adjusters, the notice of deficiency stated that the
31
A theory constitutes a new matter if it alters the
original deficiency or requires the presentation of different
evidence. Wayne Bolt & Nut Co. v. Commissioner, 93 T.C. 500, 507
(1989). A new theory that merely clarifies or develops the
original determination is not a new matter and does not shift the
burden of proof to the Commissioner. Id.; see also Shea v.
Commissioner, 112 T.C. 183 (1999); Achiro v. Commissioner, 77
T.C. 881, 890 (1981). If the Commissioner fails to notify the
taxpayer in the notice of deficiency, or the pleadings, with
respect to a particular theory and causes harm or prejudice to
the taxpayer in the preparation of his case, the Commissioner may
not rely on that theory. William Bryen Co. v. Commissioner, 89
T.C. 689, 707 (1987).
- 31 -
officers’ compensation was “‘excessive’” and “‘[exceeded] a
reasonable allowance for salaries or other compensation for
personal services actually rendered within the ambit of * * *
[section 162].’” Id. at 361-362. The Court of Appeals for the
Ninth Circuit concluded that the notice’s language apprised the
taxpayer of the Code section at issue, section 162, and
emphasized that the test of section 162 is two-pronged, requiring
that compensation be reasonable and for personal services
actually rendered. Id. at 362.
Unlike the notice of deficiency at issue in Nor-Cal
Adjusters, the notice in the present case did not expressly refer
to section 162 or make a specific determination as to whether Mr.
Menard’s compensation was for personal services actually
rendered. Even so, in a recent case, we indicated that
respondent need not specifically state the disguised dividend
theory in the notice of deficiency. In E.J. Harrison & Sons,
Inc. v. Commissioner, T.C. Memo. 2003-239, the Commissioner
determined that the amounts the taxpayer deducted for
compensation paid to its president were “unreasonable and
excessive”.32 For the first time on brief, the Commissioner
argued that the disallowed amounts were a disguised dividend.
32
Our opinion in E.J. Harrison & Sons, Inc. v. Commissioner,
T.C. Memo. 2003-239, did not excerpt the language from the notice
of deficiency that explained the Commissioner’s disallowance of
deductions for officer compensation.
- 32 -
Although the taxpayer did not contend that the disguised dividend
argument constituted a new matter, citing Nor-Cal Adjusters, we
noted that we would have rejected any such argument. See E.J.
Harrison & Sons, Inc. v. Commissioner, supra.
We agree with respondent that the notice of deficiency was
broad enough to encompass a disguised dividend theory. The
phrase “unreasonable and excessive” implicitly invoked section
162(a)(1), which expressly provides that the compensation must be
for personal services actually rendered. See also section 1.162-
7(a), Income Tax Regs., which confirms that there is a single
test for deductibility of compensation that examines whether the
payments were reasonable and, in fact, were payments purely for
services. Moreover, Menards’s characterization in its petition
of Mr. Menard’s compensation as “an ordinary and necessary
business expenditure”, which respondent then denied in the
answer, demonstrated Menards’s understanding that section
162(a)(1) was involved. See Zmuda v. Commissioner, 731 F.2d
1417, 1420 (9th Cir. 1984) (taxpayer’s comprehension of the
theories encompassed by the notice’s language was evident in the
pleadings), affg. 79 T.C. 714 (1982).
For the above reasons, therefore, we conclude that the
notices of deficiency were sufficient to raise both the
“reasonableness” and “purely for services” prongs of the section
162 test for deductibility of the compensation at issue and that
- 33 -
petitioners were neither prejudiced nor surprised by respondent’s
argument.
B. Reasonableness of the Amount of Compensation
1. The Independent Investor Test
Under section 162(a)(1) the first prong of the test for the
deductibility of compensation requires that the amount of
compensation be reasonable. Petitioners and respondent agree
that the independent investor test of Exacto Spring Corp. v.
Commissioner, 196 F.3d 833 (7th Cir. 1999), revg. Heitz v.
Commissioner, T.C. Memo. 1998-220, applies to our analysis of
reasonableness. See Golsen v. Commissioner, 54 T.C. 742, 757
(1970) (holding that we must “follow a Court of Appeals decision
which is squarely in point where appeal from our decision lies to
that Court of Appeals and to that court alone”), affd. 445 F.2d
985 (10th Cir. 1971).
In Exacto Spring Corp. the Court of Appeals for the Seventh
Circuit rejected the multifactor test used by this Court and
several Courts of Appeals33 to decide whether compensation is
reasonable, and, in its place, adopted the independent investor
33
See, e.g., RAPCO, Inc. v. Commissioner, 85 F.3d 950 (2d
Cir. 1996), affg. T.C. Memo. 1995-128; Owensby & Kritikos, Inc.
v. Commissioner, 819 F.2d 1315 (5th Cir. 1987), affg. T.C. Memo.
1985-267; Elliotts, Inc. v. Commissioner, 716 F.2d 1241 (9th Cir.
1983), revg. and remanding T.C. Memo. 1980-282; Pepsi-Cola
Bottling Co. v. Commissioner, 528 F.2d 176 (10th Cir. 1975),
affg. 61 T.C. 564 (1974); Mayson Manufacturing Co. v.
Commissioner, 178 F.2d 115 (6th Cir. 1949), affg. a Memorandum
Opinion of this Court.
- 34 -
test. Under the independent investor test as adopted by the
Court of Appeals for the Seventh Circuit, 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.
This presumption of reasonableness 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 actually performed by someone else. Id. On
brief, respondent conceded that Mr. Menard’s compensation
satisfied the independent investor test.
Although we agree with respondent that Mr. Menard’s
compensation satisfies the independent investor test as
articulated in Exacto Spring Corp., our inquiry into whether the
compensation was reasonable in amount does not end there.34 In
34
Respondent conceded in his posttrial brief that the rate
of return generated by Menards for the TYE 1998 was sufficient to
satisfy the independent investor test and did not argue that the
presumption created thereby was rebutted by evidence that the
compensation paid to Mr. Menard was substantially and
unreasonably higher than the compensation paid to CEOs in
comparable companies. Respondent chose instead to argue only
that the disallowed portion of Mr. Menard’s compensation was a
disguised dividend. It is within our discretion to accept or
reject a concession. Fazi v. Commissioner, 105 T.C. 436, 444
(1995) (citing Jones v. Commissioner, 79 T.C. 668, 673 (1982),
and McGowan v. Commissioner, 67 T.C. 599, 601, 605 (1976)). “We
may accept a concession or choose to decide the underlying
substantive issues as justice requires.” Id. Because we believe
(continued...)
- 35 -
Exacto Spring Corp., the Court of Appeals for the Seventh Circuit
did not address the factual situation now before us where the
investors’ rate of return on their investment generated by the
taxpayer corporation, a closely held corporation, is sufficient
to create a rebuttable presumption that the compensation paid to
the corporation’s CEO is reasonable, but the compensation paid by
the taxpayer corporation to its CEO substantially exceeded the
compensation paid by comparable publicly traded corporations to
their CEOs. We turn to the opinion of the Court of Appeals for
the Seventh Circuit in Exacto Spring Corp. for guidance.
In Exacto Spring Corp. v. Commissioner, supra at 838, the
Court of Appeals for the Seventh Circuit stated as follows:
In the case of a publicly held company, where the
salaries of the highest executives are fixed by a board
of directors that those executives do not control, the
danger of siphoning corporate earnings to executives in
the form of salary is not acute. The danger is much
greater in the case of a closely held corporation, in
which ownership and management tend to coincide;
unfortunately, as the opinion of the Tax Court in this
case illustrates, judges are not competent to decide
what business executives are worth.
Implicit in the above statement is the apparent belief of the
Court of Appeals for the Seventh Circuit that compensation of a
34
(...continued)
that we are required by sec. 1.162-7, Income Tax Regs., to
consider evidence of how the marketplace values the services of
comparably situated executives in deciding whether the
presumption of reasonableness has been rebutted, we shall treat
respondent’s concession as a concession that a presumption of
reasonableness arose and evaluate the evidence in deciding
whether Mr. Menard’s compensation was reasonable.
- 36 -
CEO fixed by an independent board of directors of a publicly
traded company is more likely than not to represent legitimate
compensation established by the marketplace and not disguised
dividends. Although the Court of Appeals for the Seventh Circuit
made it abundantly clear in Exacto Spring Corp. that a trial
court should not ordinarily second-guess a corporation’s decision
regarding the compensation of its CEO as long as a satisfactory
rate of return on investment, adjusted for risk, is obtained for
shareholders, the Court of Appeals for the Seventh Circuit did
not extend the same criticism to the marketplace. In fact, the
Court of Appeals for the Seventh Circuit acknowledged the
reliability of compensation decisions by publicly traded
corporations but apparently was not presented with, nor did it
decide, whether evidence that comparable publicly traded
companies paid substantially less compensation to their CEOs was
sufficient to rebut the presumption of reasonableness that
attaches to the compensation paid to a CEO of a closely held
corporation like the one in this case.
To answer the question, we turn to section 1.162-7(b)(3),
Income Tax Regs., which provides:
In any event the allowance for the compensation
paid may not exceed what is reasonable under all the
circumstances. It is, in general, just to assume that
reasonable and true compensation is only such amount as
would ordinarily be paid for like services by like
enterprises under like circumstances. * * *
- 37 -
The Court of Appeals for the Seventh Circuit did not discuss the
above-quoted regulation in Exacto Spring Corp. v. Commissioner,
supra, or declare it invalid. Neither party in this case has
challenged the regulation or argued that it exceeds the
Treasury’s delegated authority to construe section 162. Treasury
regulations “constitute contemporaneous constructions by those
charged with administration of these statutes which should not be
overruled except for weighty reasons.” Commissioner v. S. Tex.
Lumber Co., 333 U.S. 496, 501 (1948) (citing Fawcus Mach. Co. v.
United States, 282 U.S. 375, 378 (1931)); see also Carle Found.
v. United States, 611 F.2d 1192, 1196 (7th Cir. 1979) (“It is
well established that the regulations must be given great weight
absent a showing that they are unreasonable or inconsistent with
congressional intent.”); Anesthesia Serv. Med. Group, Inc. v.
Commissioner, 85 T.C. 1031, 1048 (1985), affd. 825 F.2d 241 (9th
Cir. 1987). As we read section 1.162-7, Income Tax Regs., we are
required to consider evidence of compensation paid to CEOs in
comparable companies when such evidence is introduced to show the
reasonableness or unreasonableness of a CEO’s compensation.
Because each of the parties offered expert testimony on the
reasonableness of Mr. Menard’s compensation that relied upon data
from publicly traded companies that the parties agreed are
comparable, we must consider such evidence in deciding whether
the presumption of reasonableness that respondent has conceded
- 38 -
arose from Menards’s rate of return on its shareholders’
investment for TYE 1998 has been rebutted. Accordingly, we shall
review the parties’ experts’ comparisons of Mr. Menard’s
compensation to compensation paid to CEOs by comparable publicly
traded companies and consider them in deciding whether Mr.
Menard’s salary for 1998 was reasonable within the meaning of
section 162.
2. Expert Reports
At trial, petitioner and respondent presented expert
testimony comparing Mr. Menard’s compensation with the
compensation paid to CEOs in comparable companies. In reviewing
the conclusions of each expert, we may accept or reject the
testimony according to our own judgment, and we may be selective
in deciding what parts of the experts’ opinions, if any, we
accept. See Parker v. Commissioner, 86 T.C. 547, 561-562 (1986).
a. Petitioners’ Expert
Petitioners’ expert on valuing CEO compensation was Craig
Rowley, vice president of national retail practice of Hay Group,
Inc., an international management consulting firm known for
compensation analysis and design.
(i) Comparable Companies
For purposes of comparing Mr. Menard’s compensation with
that of similarly situated executives, Mr. Rowley selected a
comparison group of publicly traded companies that sold hard
- 39 -
goods products, experienced sustained sales growth and
profitability between 1988 and 1998, and attained $1 billion in
annual revenue by 1998. The following 12 companies met these
criteria: Barnes & Noble, Best Buy, Borders, Circuit City, CVS,
Home Depot, Kohl’s, Lowe’s, Staples, Target, Wal-Mart, and
Walgreen.
(ii) Proxy Statements
Using the comparison group companies’ proxy statements filed
with the Securities and Exchange Commission (SEC) for 1988
through 1998, Mr. Rowley obtained compensation data with respect
to salaries, bonuses, and long-term incentives (LTI).35 To
better reflect compensation for services rendered, Mr. Rowley
examined the comparable companies’ proxy statements for TYE 1999
in his analysis of compensation for TYE 1998.36 According to Mr.
Rowley, companies do not make variable compensation decisions
before the end of the fiscal year, and stock options shown on the
proxy statements as granted in TYE 1999 actually compensated
executives for services performed in TYE 1998.
35
All but two of the companies in Mr. Rowley’s comparison
group compensated their CEOs with long-term incentives in the
form of stock options and/or restricted stock awards.
36
For comparison companies with fiscal years ending in
December 1998, however, because Menards’s fiscal year ended in
January 1998, Mr. Rowley used the comparison companies’ TYE 1998
proxy statements.
- 40 -
(iii) LTI Valuation Methodology
In his analysis of the comparison group’s proxy statements,
Mr. Rowley used a formula for valuing LTI compensation that he
referred to as the “Growth Model”. According to Mr. Rowley, the
Growth Model projects the actual, as opposed to the theoretical,
value of LTI compensation that a CEO will receive.
Pursuant to the Growth Model, first, Mr. Rowley assumed that
the stock prices would appreciate from the original grant price
at a 10-percent annual rate. Mr. Rowley derived the 10-percent
growth rate from an SEC proxy statement instruction, which
requires that companies report the potential realizable value of
stock option grants37 at both 5-percent and 10-percent
appreciation rates. See 17 C.F.R. sec. 229.402(c)(2)(vi)(A)
(2004). Because the comparison group contained only high-
performing companies and the stock market had a 15-percent growth
rate during the period, Mr. Rowley explained, he opted for the
10-percent growth rate. Secondly, Mr. Rowley assumed that the
recipient would hold the stock “for the typical 10 year term”38
and calculated the LTI compensation value. Lastly, Mr. Rowley
discounted the LTI compensation value to its present value using
37
On their proxy statements, companies may substitute the
potential realizable value of the stock option grants with the
present value of the grants under any option-pricing model. See
17 C.F.R. sec. 229.402(c)(2)(vi)(B) (2004).
38
According to Mr. Rowley, most long-term incentive stock
option grants are for a period of 10 years.
- 41 -
the applicable Treasury rate. Mr. Rowley did not discount for
future dividend payments or the possibility that the options may
not be exercised.39
(iv) Mr. Rowley’s Conclusion
In Mr. Rowley’s opinion, after conducting a financial
analysis of Menards and the comparison group companies, “a CEO of
Mr. Menard’s talents and results would be paid at the 90th
percentile or higher.” According to the financial analysis,
Menards performed in the 90th percentile with respect to its
return on equity, return on assets, and return on capital and
below the 10th percentile with respect to average debt. Mr.
Rowley concluded that Menards would want to reward Mr. Menard for
the company’s increased market share in home improvement sales40
and high sustained earnings by compensating Mr. Menard at or
above the 90th percentile.
Combining each CEO’s salary, bonus, and LTI to arrive at
“total direct compensation”, Mr. Rowley computed 25th, 50th,
75th, and 90th percentile categories of $7,839,787, $11,496,214,
$15,974,951, and $19,272,533, respectively. According to these
39
In support of his decision against discounting for
dividends or forfeiture, Mr. Rowley testified that CEOs “don’t
think about” dividends and stay in their positions “for a long
time” and hold onto their options.
40
Mr. Rowley based his conclusion that Menards increased its
market share on Menards’s substantial increase in sales and
multiple new store openings over the years.
- 42 -
numbers, Mr. Menard’s compensation exceeded the 90th percentile
of total direct CEO compensation for TYE 1998.41
b. Respondent’s Expert
Respondent’s expert on valuing CEO compensation was Dr.
Scott D. Hakala, principal, CBIZ Valuation Group, Inc. Dr.
Hakala has testified previously before this Court as a reasonable
compensation expert. See, e.g., Brewer Quality Homes, Inc. v.
Commissioner, T.C. Memo. 2003-200.
(i) Comparable Companies
For his analysis, Dr. Hakala selected a comparison group and
divided it into two sets. The first set comprised the other two
major home improvement retail chains, Home Depot and Lowe’s,
which Dr. Hakala described as “directly comparable” to Menards.
The second set contained seven major retail chains with “somewhat
similar operating characteristics” as Menards: Dollar General,
Kohl’s, May Department Stores, Office Depot, Staples, Target, and
TJX.
(ii) Proxy Statements
Instead of using TYE 1999 proxy statements for analyzing TYE
1998 compensation, Dr. Hakala extracted data from TYE 1998 proxy
41
Mr. Rowley also compared Mr. Menard’s compensation to 17
leading U.S. retailers using the Hay Retail Industry Senior
Executive Remuneration Survey. Because petitioners failed to
establish that these surveyed companies are comparable to
Menards, we do not consider this portion of Mr. Rowley’s
analysis.
- 43 -
statements. Dr. Hakala believed that the TYE 1998 proxy
statements reflected compensation for services performed in TYE
1998.
(iii) LTI Valuation Methodology
In contrast with Mr. Rowley’s approach to valuing LTI
compensation, Dr. Hakala used the Black-Scholes option-pricing
model (Black-Scholes)42 to determine the theoretical value of the
stock options. Both Mr. Rowley and Dr. Hakala agree that Black-
Scholes is a method for valuing stock options generally accepted
by valuation experts. To arrive at the values of the stock
options, Dr. Hakala considered the following five Black-Scholes
variables: (1) Underlying stock price, (2) exercise price, (3)
volatility, (4) risk-free interest rate, and (5) time to
expiration of the option.
After computing the Black-Scholes values of the stock
options, Dr. Hakala took a 50-percent discount to arrive at a
“market value”. According to Dr. Hakala, as a result of certain
Black-Scholes assumptions, for example, the assumption that
investors are risk-neutral, Black-Scholes artificially inflates
stock option values. In reality, Dr. Hakala explained, CEOs are
risk averse and exercise their options early or, due to death,
disability, retirement, resignation, or termination, forfeit
42
See Black & Scholes, “The Pricing of Options and Corporate
Liabilities”, 81 J. Pol. Econ. 637 (1973).
- 44 -
their options. Dr. Hakala also intended that the 50-percent
discount account for the restriction on transferability of
employee stock options.
Next, Dr. Hakala calculated a 3-year moving average of the
stock options’ discounted Black-Scholes values, in order to
“smooth out the volatility between varying magnitudes of options
awarded in different years”.43 Dr. Hakala based his decision to
use the moving average on the Financial Accounting Standards
Board’s Statement of Financial Accounting Standards (SFAS) No.
123. According to Dr. Hakala, SFAS No. 123 requires proration of
stock option values over the vesting period and, as a result,
reflects stock option values over a continued period of
performance.
(iv) Dr. Hakala’s Conclusion
In Dr. Hakala’s opinion, Mr. Menard’s compensation was
“dramatically higher” than compensation paid to the CEOs of the
comparison group companies. Although Menards performed
comparatively well with respect to growth and profit margins, in
TYE 1998, Mr. Menard’s compensation was, in Dr. Hakala’s opinion,
approximately seven times higher than the average of Home Depot’s
and Lowe’s CEOs’ compensation and significantly higher than the
43
For example, when computing the value of stock options
granted in TYE 1998, Dr. Hakala averaged the discounted Black-
Scholes values for the stock options granted in TYE 1996, TYE
1997, and TYE 1998.
- 45 -
compensation paid to Target’s CEO. Accordingly, Dr. Hakala
concluded that Mr. Menard’s compensation was not reasonable.44
3. The Parties’ Criticisms of the Expert Reports
a. Comparable Companies
Petitioners object to the inclusion in Dr. Hakala’s
comparison group of Dollar General, May Department Stores, Office
Depot, and TJX. Petitioners assert that those four companies did
not sell hard goods products, experience sustained sales growth
and profitability from 1988 through 1998, or attain $1 billion in
revenue by 1998.
In criticism of petitioners’ comparison group companies, at
trial, respondent established that, when Mr. Rowley selected
comparable companies based on sustained sales growth and
profitability between 1988 and 1998, he did not make certain that
the same CEO ran the comparison group companies for the entire
period. Mr. Rowley testified that he was certain only that Home
Depot and Staples had the same CEO for the period but emphasized
that CEO continuity was not necessary for purposes of
“understanding the market”.
44
Dr. Hakala also compared Mr. Menard’s compensation to the
Watson Wyatt Executive Compensation Survey, a market survey which
compiles compensation data for various industries. Respondent
has not established that the surveyed companies are comparable to
Menards. Accordingly, we reject this portion of Dr. Hakala’s
analysis.
- 46 -
b. Proxy Statements
With respect to the proxy statements for the comparison
group companies, the parties are unable to agree on the
appropriate fiscal year for analyzing CEO compensation for TYE
1998. Petitioners assert that the TYE 1999 compensation data
applies, whereas respondent insists on using the TYE 1998
compensation information.
In support of their position, petitioners rely solely on the
credibility of Mr. Rowley. From his representation of retailers
throughout the United States, Mr. Rowley found that most
retailers compensate their CEOs for services rendered during a
particular fiscal year by awarding LTI shortly after the
beginning of the next fiscal year. For this reason, Mr. Rowley
assumed that compensation reported on the TYE 1999 proxy
statements was awarded for TYE 1998 services and used the TYE
1999 proxy statement compensation data in his analysis of TYE
1998.
Similarly, respondent relies on the credibility of Dr.
Hakala, who asserted that Mr. Rowley should have used the TYE
1998 proxy statements. Respondent disagrees with Mr. Rowley’s
interpretation of the proxy statements and emphasizes that Mr.
Menard’s bonus for his performance during TYE 1998 was awarded to
Mr. Menard in, and intended as compensation for, that year.
- 47 -
c. LTI Compensation Valuation Methodology
Alleging that Dr. Hakala’s valuation method, combining
Black-Scholes, a 50-percent discount for risk aversion, and a 3-
year moving average, was “fatally flawed” and “grossly
undervalued” the LTI compensation, petitioners urge us to adopt
Mr. Rowley’s valuation methodology. First, petitioners assert
that Black-Scholes is incapable of predicting actual gains with
respect to LTI compensation and that it understates the value of
stock options by placing a high premium on volatility and
discounting the value of successful companies with sustained
growth. Calling Dr. Hakala’s use of a 50-percent discount for
risk aversion “arbitrary”, petitioners claim that this approach
fails to differentiate between long-term CEOs and other
executives. Lastly, petitioners object to Dr. Hakala’s use of a
3-year moving average, arguing that it produced a significantly
lower value for the LTI compensation by combining “substantially
less successful” years with TYE 1998.
In contrast, respondent asserts that we should adopt Dr.
Hakala’s valuation methodology and entirely disregard Mr.
Rowley’s use of the Growth Model. At trial, Dr. Hakala testified
that the Growth Model is not a generally accepted method for
valuing stock options and questioned whether any valuation expert
would accept Mr. Rowley’s methodology.
- 48 -
Respondent offers several specific criticisms of Mr.
Rowley’s valuation method. First, respondent criticizes Mr.
Rowley’s failure to consider restrictions on the time before
exercise of the options, arguing that this omission artificially
inflated the stock options’ values. Secondly, respondent
challenges as unsubstantiated Mr. Rowley’s assumption that the
underlying stock would appreciate at an annual rate of 10 percent
over a 10-year period and that the CEOs would hold the options
for a full 10 years. Respondent also argues that Mr. Rowley
inappropriately obtained the 10-percent appreciation rate from
SEC proxy statement filing instructions that are unrelated to the
valuation of stock options. Finally, respondent criticizes Mr.
Rowley’s methodology for refusing to take the possibility of
dividends into account even though the payment of dividends
decreases a corporation’s value and results in a corresponding
decrease in stock option value.
4. Analysis
a. Comparable Companies
Although Mr. Rowley and Dr. Hakala used several different
companies in their respective comparison groups, the two experts
agreed that five companies were comparable to Menards: Home
Depot, Kohl’s, Lowe’s, Staples, and Target. On brief, respondent
stated that the five companies “are probably a sufficient sample”
for comparing CEO compensation. On the basis of the experts’
- 49 -
agreement with respect to the five companies listed above and the
lack of evidence establishing that the other companies are truly
comparable to Menards, we consider only CEO compensation paid by
Home Depot, Kohl’s, Lowe’s, Staples, and Target.
b. Proxy Statements45
We disagree with petitioners’ contention that the comparison
group companies’ TYE 1999 proxy statements reported compensation
paid for TYE 1998 services. The SEC Standard Instructions (the
SEC instructions) for filing proxy statements provide that “If
the CEO served in that capacity during any part of a fiscal year
with respect to which information is required, information should
be provided as to all of his or her compensation for the full
fiscal year.” 17 C.F.R. sec. 229.402(a)(4) (2004) (emphasis
added). Furthermore, the SEC instructions for the proxy
statement’s summary compensation table state that the table shall
include executive compensation “earned by the named executive
officer during the fiscal year covered”. 17 C.F.R. sec.
229.402(b)(2)(iii) (emphasis added). Even assuming that Mr.
Rowley is correct that companies do not make their decisions with
respect to bonuses and LTI compensation until a few months after
the beginning of the next fiscal year, the bonuses and LTI
45
In the past, we have permitted the use of SEC proxy
statement data for the comparison of an executive’s compensation
to comparable companies’ executives’ compensation. See Square D
Co. & Subs. v. Commissioner, 121 T.C. 168 (2003).
- 50 -
intended as compensation for TYE 1998 would be reported on the
TYE 1998 proxy statements, pursuant to the SEC instructions.
Accordingly, we accept Dr. Hakala’s compensation figures taken
from the TYE 1998 proxy statements.
c. LTI Compensation Valuation Methodology
In defense of Mr. Rowley’s valuation methodology,
petitioners cite articles in the American Compensation
Association Journal.46 Though the articles lend support to the
existence of Mr. Rowley’s Growth Model, we are not persuaded that
the model is generally accepted by valuation experts or that it
provides a reasonably accurate value for the LTI compensation.
Petitioners have failed to establish that Mr. Rowley’s selection
of a 10-year period until exercise of the options and a 10-
percent growth rate was appropriate. We find it particularly
troublesome that Mr. Rowley derived the 10-percent growth rate
from the SEC instructions for reporting potential realizable
value of stock options. At trial, Mr. Rowley admitted, and Dr.
Hakala confirmed, that the SEC requirement is actually intended
to illustrate amounts that executives can earn on stock options
at a 10-percent growth rate and is not a rule for valuing stock
options.
46
See, e.g., Buyniski & Silver, “Determining the
Compensation Value of Stock Options”, 9 Am. Comp. Association J.
66 (Jan. 2000) (contrasting Black-Scholes with another model
similar to Mr. Rowley’s Growth Model called the Present Value of
Expected Gain).
- 51 -
After reviewing both experts’ methodologies, we conclude
that Black-Scholes is a more credible stock option valuation
method than the Growth Model. Unlike Mr. Rowley’s Growth Model,
Black-Scholes accounts for the effects of dividends and
volatility on the stock options’ values. Moreover, generally
accepted accounting principles support the use of Black-Scholes
for valuing stock options. For example, paragraph 19 of SFAS No.
123 requires for financial reporting purposes that companies use
a fair value method of accounting, such as Black-Scholes, to
estimate the companies’ stock option expenses.47 Furthermore, we
disagree with petitioners’ contention that Black-Scholes
understates the options’ values. Considering that Black-Scholes
does not account for transfer restrictions, vesting periods, or
the risk of forfeiture, Black-Scholes more likely overstates the
options’ values.
In support of Dr. Hakala’s decision to alter the Black-
Scholes value by taking a 50-percent discount for risk aversion,
respondent cites articles in accounting journals that describe
the valuation approach of SFAS No. 123 and discuss the prevalence
and implications of forfeiture and early exercise of employee
47
Paragraph 19 of SFAS No. 123 actually recommends a
slightly modified version of Black-Scholes in that the SFAS No.
123 model replaces the actual-time-to-expiration variable with
the expected life of the option. In paragraph 169, SFAS No. 123
explains that this substitution reflects the restrictions on
transferability of employee stock options.
- 52 -
stock options.48 In addition, at trial, Dr. Hakala testified
that, due to risk aversion, vesting periods, and early
terminations, most executives do not wait 10 years to exercise
their options and, as a result, on average, realize only one-half
of the Black-Scholes value. Dr. Hakala based this opinion on
academic studies and his own personal research on insider trading
and executive options. In rebuttal, Mr. Rowley testified that,
in his experience, CEOs of retail companies do not exercise their
options early or allow them to lapse.
Although we find it difficult to believe, as Mr. Rowley
suggests, that CEOs of retail companies never forfeit their stock
options, we cannot agree with respondent that a 50-percent
discount of the Black-Scholes value is appropriate. Other than
Dr. Hakala’s personal observations, respondent has not introduced
any evidence establishing that valuation experts would apply a
discount as large as 50 percent to account for risk aversion.
The articles cited by respondent do not recommend a 50-percent
discount, and, in Dr. Hakala’s report, he did not substantiate
his choice of a 50-percent discount over other possible
discounts. Moreover, Dr. Hakala did not consider the comparison
group companies’ own exercise and forfeiture patterns. Even if,
as Dr. Hakala testified, employee stock options generally realize
48
See, e.g., Botosan & Plumlee, “Stock Option Expense: The
Sword of Damocles Revealed”, 15 Acct. Horizons 311 (Dec. 2001).
- 53 -
only one-half of their Black-Scholes value, here, we are not
dealing with companies in general. We are examining a group of
companies that are comparable to Menards, and Dr. Hakala should
have focused his valuation on those companies. After rejecting
the 50-percent discount for the foregoing reasons, the record
leaves us with no alternative but to move on to our review of the
3-year moving average.
Though intended to justify the 3-year moving average, Dr.
Hakala’s report and trial testimony establish only that the
options’ values should be prorated over the options’ vesting
periods. At trial, Dr. Hakala explained that he based the 3-year
moving average on the recommendation in SFAS No. 123 to prorate
over the vesting period, and, in his report, he stated that the
3-year moving average was “in line with the vesting schedules
underlying the options.” Ignoring the obvious chronological
inconsistency in the latter justification, a 3-year moving
average of options awarded in TYE 1996, TYE 1997, and TYE 1998 is
still quite different from prorating the stock options’ values
over the vesting period. As noted by petitioners, a 3-year
moving average combines potentially less successful previous
years with the TYE 1998 options’ values. Furthermore, the 3-year
moving average does not treat the options as only partially
vested in the first year. In the absence of evidence to
- 54 -
substantiate the 3-year moving average, we must reject this
portion of Dr. Hakala’s valuation methodology.
5. Conclusion
After evaluating both experts’ valuation methodologies in
light of the record, we now compare Mr. Menard’s TYE 1998
compensation to the Black-Scholes values of compensation paid in
TYE 1998 to CEOs of Home Depot, Kohl’s, Lowe’s, Staples, and
Target. With one exception,49 we use Dr. Hakala’s Black-Scholes
stock option values computed before discounts.
The comparison group companies compensated their CEOs for
services performed in TYE 1998 in the following amounts:
Company Compensation
1
Home Depot $2,841,307
Kohl’s 5,110,578
Lowe’s 6,054,977
Staples 6,868,747
Target 10,479,528
1
Home Depot did not compensate its CEO with stock options or
restricted stock awards.
49
Pursuant to rule 201 of the Federal Rules of Evidence, we
take judicial notice of the TYE 1998 proxy statements filed with
the Securities and Exchange Commission to the extent that they
represent reported compensation for TYE 1998.
Target’s proxy statement for its TYE 1998 reported that the
options awarded to the CEO for that year included all options
that would be granted to the CEO over a 3-year period.
Accordingly, for the Black-Scholes value of Target’s CEO’s stock
options in TYE 1998, we use only one-third of the value that Dr.
Hakala computed.
- 55 -
Mr. Menard’s compensation of $20,642,485 is nearly two times
higher than Target’s CEO’s compensation, more than three times
higher than Staples’s and Lowe’s CEOs’ compensation, more than
four times higher than Kohl’s CEO’s compensation, and more than
seven times higher than Home Depot’s CEO’s compensation. After
comparing Mr. Menard’s compensation to the comparison group
companies’ CEOs’ compensation, we conclude that (1) Mr. Menard’s
compensation substantially exceeded the compensation paid by
comparable publicly traded companies to their CEOs, and (2) such
evidence was sufficient to rebut the presumption of
reasonableness created by Menards’s rate of return on investment.
Consequently, we examine the total record to decide what portion
of Mr. Menard’s compensation was reasonable.
In his report, Mr. Rowley asserted that Menards’s
performance in TYE 1998 demonstrated that Mr. Menard’s
compensation should be at or above the 90th percentile of the
comparison group companies’ compensation. We disagree. Nothing
in the record suggests that, for a company of Menards’s size and
growth, compensating Mr. Menard at or above the 90th percentile
is reasonable. Even so, certain measures of Menards’s
performance relied upon by Dr. Hakala and Mr. Rowley in their
reports, and reproduced in the appendix to this Opinion, indicate
that Mr. Menard’s compensation should be much higher than the
$1,380,876 that respondent allowed. We now must compare
- 56 -
Menards’s performance to the comparison group companies’
performances to determine how the marketplace valued services
comparable to those provided to Menards by Mr. Menard during TYE
1998 and to decide what portion of Mr. Menard’s compensation was
reasonable within the marketplace. See Exacto Spring Corp. v.
Commissioner, 196 F.3d at 838; sec. 1.162-7(b)(3), Income Tax
Regs.
Although comparisons to Kohl’s, Staples, and Target are
helpful to an extent, we can more accurately gauge a reasonable
amount of compensation for Mr. Menard by focusing on how Menards
compared to its direct competitors in home improvement retailing,
Home Depot and Lowe’s, during TYE 1998. In his report, Dr.
Hakala described Home Depot and Lowe’s as “directly comparable”
to Menards. Similarly, while contrasting Menards’s performance
during TYE 1998 with Home Depot’s and Lowe’s performances,
petitioners characterized the two companies as Menards’s “closest
competitors”. In TYE 1998, Home Depot, Lowe’s, and Menards had
gross revenue, revenue growth, and net income as follows:
- 57 -
Company Gross Revenue Revenue Growth Net Income
1
Home Depot $24.156 23.7% $1.160
Lowe’s 10.137 17.9 0.357
2
Menards 3.420 12.7 0.204
1
All dollar amounts are in billions and have been rounded to
the nearest million.
2
A slight discrepancy existed between Mr. Rowley’s and Dr.
Hakala’s numbers for the value of Menards’s net income for TYE
1998. See Appendix. After comparing the expert reports to
Menards’s TYE 1998 financial statement, we accept the net income
value as contained in Mr. Rowley’s report.
Across all three measures, Menards performed in third place. In
contrast, however, Menards had the highest return on equity and
return on assets of its direct competitors:50
Return on Return on
Company Equity Assets
Menards 18.8% 14.2%
Home Depot 16.1 10.3
Lowe’s 13.7 6.8
50
Mr. Rowley calculated the companies’ returns on “beginning
shareholders’ equity”, “average shareholders’ equity”, and
“average assets”, but did not explain how he arrived at those
numbers or why he used such variations on return on equity.
Additionally, petitioners’ expert on investor returns, John
Gilbertson of Goldman, Sachs & Co., calculated returns on
“beginning shareholders’ equity”, “average shareholders’ equity”,
“beginning assets”, and “average assets”. Although Mr.
Gilbertson explained how he arrived at those numbers, other than
stating his rationale for emphasizing the return on average
shareholders’ equity over the return on beginning shareholders’
equity, Mr. Gilbertson did not explain why he used these
variations on return on equity and return on assets. In the
absence of credible evidence to explain the calculations made by
petitioners’ experts, we shall rely on Dr. Hakala’s values
computed for the companies’ return on equity and return on
assets.
- 58 -
Ultimately, when compared to Home Depot and Lowe’s, during
TYE 1998, Menards was a small company that experienced less
substantial revenue growth but generated a comparatively high
return on equity. Considering the emphasis of the Court of
Appeals for the Seventh Circuit on investors’ returns in Exacto
Spring Corp. v. Commissioner, supra at 838-839, in arriving at a
reasonable amount of compensation, we attribute the most
importance to Menards’s comparatively high return on equity. We
conclude, therefore, that as the home improvement retailer with
the highest return on equity, Menards’s CEO’s compensation should
be the highest value within the range of its direct competitors’
CEOs’ compensation.
Although Home Depot generated a higher return on equity than
Lowe’s did during TYE 1998, the amount of compensation that the
CEO of Lowe’s received was approximately 2.13 times higher than
the amount of compensation that Home Depot’s CEO received. Due
to this lack of correlation between the rates of return on equity
and the CEO compensation of Menards’s direct competitors, we
calculate a reasonable amount of compensation for Mr. Menard in
the following manner:
16.1 (HD ROR) = 18.8 (M ROR)
$2,841,307 (HD Comp) $ (M Comp)
M Comp = $3,317,799 x 2.13 = $7,066,912
Consequently, Menards is entitled to deduct $7,066,912 as
compensation paid to Mr. Menard during TYE 1998.
- 59 -
C. Compensation for Services Actually Rendered
Although we have concluded that only a portion of Mr.
Menard’s compensation was reasonable in amount, as an alternative
basis for our decision, we now consider whether Mr. Menard’s
compensation was payment for services actually rendered. In
cases involving a closely held corporation, compensation paid to
a shareholder-employee is not the product of arm’s-length
bargaining and deserves special scrutiny. Charles Schneider &
Co. v. Commissioner, 500 F.2d 148, 152 (8th Cir. 1974), affg.
T.C. Memo. 1973-130; see also Exacto Spring Corp. v.
Commissioner, supra at 838. This is particularly so in this case
because the board of directors consisted of Mr. Menard; Mr.
Menard’s brother, L. Menard; and Mr. Rasmussen, who depended on
Mr. Menard for his own annual bonus. Respondent contends that
$19,261,609 of Mr. Menard’s compensation was a disguised
dividend.
In Exacto Spring Corp. v. Commissioner, 196 F.3d at 835, the
Court of Appeals for the Seventh Circuit stated that the “primary
purpose of section 162(a)(1)” is to prevent corporations from
disguising dividends as salary. The Court of Appeals for the
Seventh Circuit 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 for the Seventh
- 60 -
Circuit 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 we decide on the basis of
the facts and circumstances of the case. Paula Constr. Co. v.
Commissioner, 58 T.C. 1055, 1059 (1972), affd. without published
opinion 474 F.2d 1345 (5th Cir. 1973). Compensatory intent is
subjective and difficult to prove. O.S.C. & Associates, Inc. v.
Commissioner, 187 F.3d 1116, 1120 (9th Cir. 1999), affg. T.C.
Memo. 1997-300; Elliotts, Inc. v. Commissioner, 716 F.2d 1241,
1243 (9th Cir. 1983), revg. and remanding T.C. Memo. 1980-282.
If the Commissioner introduces evidence suggesting that the
compensation was a disguised dividend, even if the payment was
reasonable in amount, we inquire into whether the taxpayer had a
compensatory purpose for the payment. O.S.C. & Associates, Inc.
v. Commissioner, supra at 1121; Elliotts, Inc. v. Commissioner,
supra at 1243-1244. The taxpayer’s failure to pay dividends
since its formation, alone, is not sufficient evidence of a
disguised dividend. Elliotts, Inc. v. Commissioner, supra at
1244. However, the presence of the following six factors
indicates that compensation was not intended for personal
- 61 -
services rendered: (1) Bonuses paid in exact proportion to
officers’ shareholdings; (2) payments made in lump sums rather
than as the services were rendered; (3) a complete absence of
formal dividend distributions by an expanding corporation; (4) a
completely unstructured bonus system, lacking relation to
services performed; (5) consistently negligible taxable corporate
income; and (6) bonus payments made only to the officer-
shareholders. See O.S.C. & Associates, Inc. v. Commissioner,
supra at 1121; Nor-Cal Adjusters v. Commissioner, 503 F.2d at
362; Wagner Constr., Inc. v. Commissioner, T.C. Memo. 2001-160.
Although not all six factors from the list, supra, are
present with respect to Mr. Menard’s compensation,51 other
factors demonstrate that a portion of Mr. Menard’s compensation
was a disguised dividend. One relevant factor is that Menards
has never paid a dividend, despite its tremendous growth over the
years.52 In addition, Menards paid the 5-percent bonus in one
51
During TYE 1998, Mr. Menard was the only officer-
shareholder who received a bonus. Chris Menard was a class B
shareholder, but the record does not indicate whether he received
a bonus during TYE 1998.
Additionally, during TYE 1998, although other executives
received bonuses, Mr. Menard’s bonus was firmly set at 5 percent
of Menards’s net income before taxes, and the record contains no
evidence that Menards had consistently negligible taxable income.
52
We recognize that, in Exacto Spring Corp. v. Commissioner,
196 F.3d 833, 837 (7th Cir. 1999), revg. Heitz v. Commissioner,
T.C. Memo. 1998-220, in rejecting the multifactor test, the Court
of Appeals for the Seventh Circuit observed that “the low level
(continued...)
- 62 -
lump sum rather than as Mr. Menard performed services. Perhaps
more problematic, this lump-sum payment was “practically no
different from a dividend”: a profit-based, yearend bonus paid
to the majority shareholder-officer.53 See RAPCO, Inc. v.
Commissioner, 85 F.3d 950, 954 n.2 (2d Cir. 1996), affg. T.C.
Memo. 1995-128.
We also find significant Mr. Menard’s agreement to reimburse
Menards for any portion of the 5-percent bonus disallowed as a
deduction. Such reimbursement clauses suggest that the taxpayer
had preexisting knowledge that the compensation may not satisfy
section 162(a)(1) and lead to the inference that the compensation
was intended, in part, as a disguised dividend. See Charles
Schneider & Co. v. Commissioner, 500 F.2d at 155; Saia Elec.,
Inc. v. Commissioner, T.C. Memo. 1974-290, affd. without
published opinion 536 F.2d 388 (5th Cir. 1976).
Petitioners assert that Menards intended Mr. Menard’s salary
and the 5-percent bonus as compensation purely for his services.
52
(...continued)
of dividends paid by * * * [the taxpayer]” did not constitute
evidence that the CEO’s compensation was unreasonable for
purposes of the first prong of sec. 162(a)(1). However, the
Court of Appeals for the Seventh Circuit did not also reject this
factor for purposes of determining whether the compensation was
intended for personal services actually rendered. See Exacto
Spring Corp. v. Commissioner, supra at 839; see also sec.
162(a)(1).
53
We note that Mr. Menard was also one of the three
directors who approved the 5-percent bonus.
- 63 -
According to petitioners, Menards’s growth and performance were
due to “the foresight, hard work, experience, skill, decision
making ability, and energy of Mr. Menard.” With the 5-percent
bonus, petitioners argue, Menards intended to establish a
consistent method for determining Mr. Menard’s variable
compensation based on his efforts and the company’s resulting
success.
Even though Mr. Menard’s hard work contributed greatly to
Menards’s success and, as a result of that success, the 5-percent
bonus generally increased each year, we disagree with petitioners
that this arrangement evinces an intent to compensate. Although
incentive compensation may encourage nonshareholder employees to
put forth their best efforts, a majority shareholder invested in
the company to the extent of Mr. Menard does not need the
incentive. See Charles Schneider & Co. v. Commissioner, supra at
153. When large shareholders base their compensation on a
percentage of the company’s income, the arrangement may suggest
an attempt to distribute profits without declaring a dividend.
See Hampton Corp. v. Commissioner, T.C. Memo. 1964-150, affd. 16
AFTR 2d 65-5265, 65-2 USTC par. 9611 (9th Cir. 1965).
Contrary to petitioners’ argument, the board’s decision,
made during the preceding fiscal year, to designate the 5-percent
bonus as Mr. Menard’s compensation for TYE 1998 does not insulate
petitioners from the conclusion that Menards intended to
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distribute profits. With a corporation as successful and
profitable as Menards, at the time of the board’s resolution,
barring some unforeseen catastrophe, the board could count on Mr.
Menard’s receiving a sizable bonus in TYE 1998 pursuant to the
formula. Moreover, the failure of the board, whose members were
Menard employees and/or family members of Mr. Menard’s, to make
any effort to ascertain the market value of comparable corporate
executives or to periodically evaluate the formula as a gauge of
reasonable compensation, reinforces the impression that it was
used to enable Mr. Menard to claim an extravagant bonus unrelated
to the actual market value of his services as a corporate CEO.
On the basis of the evidence discussed, supra, we conclude
that Mr. Menard’s compensation was not intended entirely for
personal services rendered and contained a distribution of
profits. Any amount in excess of $7,066,912 is unreasonable and
a disguised dividend. See supra pp. 53-58. Accordingly, we hold
that Menards is entitled to deduct $7,066,912 as an ordinary and
necessary business expense pursuant to section 162(a)(1).
III. Deductibility of the TMI Expenses
Section 162(a) provides a deduction for ordinary and
necessary expenses that a taxpayer pays or incurs during the
taxable year in carrying on a trade or business. A taxpayer must
maintain books of account or records sufficient to establish the
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amount of the deductions. See sec. 6001; sec. 1.6001-1(a),
Income Tax Regs.
Section 162(a) requires a taxpayer to prove that the
expenses deducted (1) were paid or incurred during the taxable
year, (2) were incurred to carry on the taxpayer’s trade or
business, and (3) were ordinary and necessary expenditures of the
business. See also Commissioner v. Lincoln Sav. & Loan
Association, 403 U.S. 345, 352 (1971). An expense is ordinary if
it is customary or usual within a particular trade, business, or
industry or relates to a transaction “of common or frequent
occurrence in the type of business involved.” Deputy v. du Pont,
308 U.S. 488, 495 (1940). An expense is necessary if it is
appropriate and helpful for the development of the business. See
Commissioner v. Heininger, 320 U.S. 467, 471 (1943). Even if an
expense is ordinary and necessary, however, the expense is
deductible only to the extent that it is reasonable in amount.
See United States v. Haskell Engg. & Supply Co., 380 F.2d 786,
788-789 (9th Cir. 1967); Ciaravella v. Commissioner, T.C. Memo.
1998-31. In general, a taxpayer who pays another taxpayer’s
business expenses may not treat those payments as ordinary and
necessary expenses incurred in the payor’s business. See
Columbian Rope Co. v. Commissioner, 42 T.C. 800, 815 (1964); see
also Interstate Transit Lines v. Commissioner, 319 U.S. 590
(1943); Deputy v. du Pont, supra at 495; S. Am. Gold & Platinum
- 66 -
Co. v. Commissioner, 8 T.C. 1297 (1947), affd. 168 F.2d 71 (2d
Cir. 1948).
A. Responsibility for the TMI Expenses–-The Alleged Oral
Sponsorship Agreement
1. The Parties’ Positions
Petitioners contend that, since TMI’s formation in 1992,
Menards and TMI have had an oral agreement that Menards would
sponsor TMI’s Indy cars. In lieu of a formal sponsorship fee,
petitioners explain, Menards agreed to pay the TMI expenses in
exchange for the “full benefits of a founding sponsor.”54 In
contrast, respondent contends that there was no oral sponsorship
agreement.
2. Terms of the Alleged Oral Sponsorship Agreement
At trial, Mr. Menard testified that when TMI was formed in
1992, Menards made an oral agreement with TMI to pay some of
TMI’s racing expenses in exchange for “all the benefits of the
sponsorship”. As Mr. Menard understood the term “benefits”, TMI
54
Petitioners describe the “full benefits” of a “founding
sponsor” to include the following:
significant, prominent name identification on the race
cars, team uniforms, transporters, race car
transporters, pit walls and all publicity and
promotional materials developed by the team and the
IRL[;] hospitality at the races for * * * [Menards’s]
suppliers, customers, and guests[;] naming rights for
the entries[;] tickets[;] access to viewing suites[;]
parking privileges[;] name and likeness grants[;] as
well as personal appearances of the TMI drivers.
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was required to do “whatever was necessary” for Menards’s
business, such as sending drivers to appear at grand openings of
Menards stores. Menards did not specify a particular amount of
TMI’s expenses that Menards would pay, Mr. Menard testified, but,
instead, agreed to cover a certain “group of expenses” in the
“amount necessary to get the job done.” Mr. Menard explained
that he had “a pretty good idea what it was going to cost.”
3. Analysis
As respondent has pointed out, the alleged oral sponsorship
agreement between Menards and TMI is essentially an oral
agreement that Mr. Menard made with himself as president of both
companies. Considering the vagueness of Mr. Menard’s description
of the alleged agreement’s terms, his testimony lacks
credibility. Two Menards executives, L. Menard and Mr. Norquist,
and Menards’s outside accountant, Mr. Stienessen, testified to
having knowledge of a sponsorship agreement between Menards and
TMI. We conclude, however, that the probative value of their
brief and somewhat self-interested testimony55 on the matter is
outweighed by the rest of the evidence.56
55
The annual compensation, including annual bonuses, of Mr.
L. Menard and Mr. Norquist was fixed by Mr. Menard, and Mr.
Stienessen, the preparer of Menards’s returns, depended upon Mr.
Menard for ongoing business.
56
We need not accept at face value a witness’s testimony
that is self-interested or otherwise questionable. See Archer v.
Commissioner, 227 F.2d 270, 273 (5th Cir. 1955), affg. a
(continued...)
- 68 -
Several factors contradict petitioners’ assertion that
Menards and TMI made an oral sponsorship agreement pursuant to
which Menards would pay certain TMI expenses in exchange for
sponsorship benefits. First, TMI did not report on its tax
return or record in its books and records any sponsorship income
from Menards, with the possible exception of $45,000 for TYE
1998. Second, TMI reported income from its other sponsors on
both its tax return and sponsorship income reports. Third,
instead of creating separate accounts in its books and records
identifying the TMI expenses as sponsorship fees or advertising
expenses, Menards commingled the payments made on TMI’s behalf
with Menards’s other business expenses. Fourth, the only
explanation provided for Menards’s accounting method was that
Menards “had historically done that * * * and * * * [Menards]
continued that practice of what * * * [it] had done in the past.”
Fifth, when Menards deducted the TMI expenses on its tax returns,
Menards did not identify the deductions as sponsorship fees or
advertising expenses.
4. Conclusion
The record contains no credible evidence of an oral
sponsorship agreement between Menards and TMI. Moreover, the
56
(...continued)
Memorandum Opinion of this Court dated Feb. 18, 1954; Weiss v.
Commissioner, 221 F.2d 152, 156 (8th Cir. 1955), affg. T.C. Memo.
1954-51; Schroeder v. Commissioner, T.C. Memo. 1986-467.
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factors discussed above strongly weigh against the alleged
agreement’s existence. On the basis of Menards’s and TMI’s
behavior with respect to the accounting and reporting of the
payments and expenses, we conclude that Menards used TMI as a
means to continue Menards’s participation in Indy racing, while
shielded from liability, but did not do so pursuant to an oral
sponsorship agreement.57 The expenses that Menards paid were
TMI’s expenses for which TMI was obligated.
B. Deductibility of One Corporation’s Payment of Another
Corporation’s Ordinary and Necessary Business Expenses58
Although a corporation generally may not deduct payments of
another corporation’s expenses,59 see supra p. 65, and Menards
did not pay TMI’s expenses pursuant to an oral sponsorship
agreement, Menards still may be entitled to a deduction. An
exception exists for cases in which the taxpayer paid the other
corporation’s ordinary and necessary business expenses in order
to “protect or promote” the taxpayer’s own business. See, e.g.,
57
We note that respondent does not allege, nor do we find,
that TMI should not be respected as a separate taxable entity.
On the contrary, TMI was formed for a business purpose and has
carried on that business since its formation. See Moline Props,
Inc. v. Commissioner, 319 U.S. 436, 439 (1943).
58
Respondent does not question whether the TMI expenses were
ordinary and necessary business expenses incurred with respect to
TMI’s business.
59
Even if the corporations were under common ownership or
control, the payor corporation may deduct, in limited
circumstances, only expenditures that further its own business.
See Oxford Dev. Corp. v. Commissioner, T.C. Memo. 1964-182.
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Scruggs-Vandervoort-Barney, Inc. v. Commissioner, 7 T.C. 779
(1946); Moloney Elec. Co. v. Commissioner, 42 B.T.A. 78 (1940),
affd. in part and revd. in part on another issue 120 F.2d 617
(8th Cir. 1941); First Natl. Bank v. Commissioner, 35 B.T.A. 876
(1937); Metro Land Co. v. Commissioner, T.C. Memo. 1981-335;
Hudlow v. Commissioner, T.C. Memo. 1971-218. In Lohrke v.
Commissioner, 48 T.C. 679, 688 (1967), we articulated a two-part
test for determining whether a taxpayer’s payments are eligible
for this exception: (1) The taxpayer’s primary motive for paying
the expenses was to protect or promote the taxpayer’s business,
and (2) the expenditures constituted ordinary and necessary
expenses in the furtherance or promotion of the taxpayer’s
business. See also Square D. Co. & Subs. v. Commissioner, 121
T.C. 168, 198-201 (2003).
1. Menards’s Primary Motive for the TMI Payments
Regarding the first prong of the Lohrke test, the taxpayer
must establish a direct nexus between the payment’s purpose and
the taxpayer’s business. See Bone v. Commissioner, T.C. Memo.
2001-43; JRJ Express, Inc. v. Commissioner, T.C. Memo. 1998-200
(citing Lettie Pate Whitehead Found., Inc. v. United States, 606
F.2d 534, 538 (5th Cir. 1979)). Accordingly, we consider whether
the taxpayer made the payments primarily to promote its
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business.60 JRJ Express, Inc. provides an example of self-
promotion as the taxpayer’s primary purpose. In JRJ Express,
Inc., the taxpayer was a courier business that delivered letters
and small packages from the United States to Guatemala. The
taxpayer’s sole shareholder’s brothers owned and controlled
several Guatemalan companies that made similar deliveries from
Guatemala to the United States and used the same company logo as
the taxpayer. Pursuant to an oral agreement, the taxpayer paid
the Guatemalan companies’ inbound expenses, in exchange for which
the Guatemalan companies printed and stuffed promotional
materials advertising the taxpayer’s business in all Guatemalan
mail bound for U.S. destinations. Id.
We concluded in JRJ Express, Inc. that the taxpayer’s
payments were primarily intended to protect or promote the
taxpayer’s delivery service. Because of the nature of the
taxpayer’s business, the promotion and marketing process was the
business’s “centerpiece”.61 Through the insertion of
60
Another consideration under the first prong of the Lohrke
test, not applicable to the present case, is whether the taxpayer
faced a “‘clear proximate danger’” and made payments “‘to protect
an existing business from harm’”. Bone v. Commissioner, T.C.
Memo. 2001-43; JRJ Express, Inc. v. Commissioner, T.C. Memo.
1998-200 (quoting Young & Rubicam, Inc. v. United States, 187 Ct.
Cl. 635, 410 F.2d 1233, 1243 (1969)).
61
In JRJ Express, Inc. v. Commissioner, supra, we also noted
that, due to the transient nature of many Guatemalan workers in
the United States, the taxpayer’s business faced a “clear
proximate danger” if the taxpayer could not maintain a “fluid
(continued...)
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advertisements in the Guatemalan mail, the taxpayer “derived a
substantial benefit not otherwise available”, which ultimately
generated much of the taxpayer’s revenues that year. The
taxpayer’s payment of the inbound expenses had a direct nexus
with the taxpayer’s business. Id.
Petitioners assert that Menards’s primary motive for paying
the TMI expenses was to promote Menards’s business and that a
direct nexus existed between the purpose of the TMI payments and
Menards’s business. Although there was no oral sponsorship
agreement between Menards and TMI, this case is similar to JRJ
Express, Inc. in that the taxpayer received a benefit in return
for paying the other corporation’s expenses. In TYE 1998,
Menards paid the TMI expenses and, for no additional fee,
received Indy race car sponsorship benefits, which, like the
benefits in JRJ Express, Inc., were advertising and promotional
benefits.
Indy racing may not be the only form of advertising
available to Menards for targeting potential customers, but
participation in motor sports is an innovative and exciting
method for generating local, national, and international
publicity for Menards’s business. Menards’s competitors’
decisions to become involved in motor sports also highlights its
61
(...continued)
mailing list” through advertising stuffed in the inbound mail.
- 73 -
appeal as a form of effective advertising. Even though Mr.
Menard had a personal interest in racing, any personal enjoyment
that he gained from Menards’s involvement in motor sports was
incidental to the benefits Menards’s business received through
its relationship with TMI.
Long before TMI’s incorporation, Menards used motor sports
as a way to publicize its business and continued that practice
after TMI’s creation. Mr. Menard testified that Menards’s intent
behind the TMI payments was to have the same racing benefits as
it did prior to TMI’s incorporation, acquire national and
international publicity through TMI’s notoriety, and promote
Menards’s products. When Mr. Menard formed TMI and named it
“Team Menard”, he indelibly associated the Menards stores with
the Indy racing team.
After carefully considering the evidence, we conclude that
to the extent we hold, infra, that the TMI expenses were
reasonable in amount, Menards’s primary motive for paying the TMI
expenses was to promote Menards’s business. Menards received
broad advertising exposure from its involvement with TMI. The
races provided opportunities for Mr. Menard and other Menards
executives to network with vendors and create and maintain
goodwill with customers. Moreover, had Menards not been
concerned about potential liability in the event of a racing
- 74 -
accident, Menards likely would not have incorporated TMI and
would have continued to sponsor race cars directly.
2. Whether the TMI Expenses Were Ordinary and
Necessary in the Furtherance of Menards’s Business
To meet the second part of the Lohrke test, the taxpayer
must demonstrate that the expenses were ordinary and necessary in
the furtherance or promotion of the taxpayer’s business. With
respect to race car sponsorship expenditures, we have held that,
to the extent the expenditures are reasonable in amount, the
taxpayer may deduct them as ordinary and necessary business
expenses attributable to advertising. See, e.g., Ciaravella v.
Commissioner, T.C. Memo. 1998-31; Gill v. Commissioner, T.C.
Memo. 1994-92, affd. without published opinion 76 F.3d 378 (6th
Cir. 1996); Boomershine v. Commissioner, T.C. Memo. 1987-384;
Brallier v. Commissioner, T.C. Memo. 1986-42; Hestnes v.
Commissioner, T.C. Memo. 1983-727, affd. without published
opinion 762 F.2d 1015 (7th Cir. 1985); Lang Chevrolet Co. v.
Commissioner, T.C. Memo. 1967-212. First, however, a taxpayer
must show that the purpose for sponsoring the racing activity was
“to gain a reasonable amount of publicity” for the taxpayer’s
business. Lang Chevrolet Co. v. Commissioner, supra. One
objective indication of the taxpayer’s intent behind the racing
expenditures is “the reasonableness of the relationship between
the amount expended for the activity compared to the amount of
benefit reasonably calculated to be derived.” Id. We now
- 75 -
consider whether the amount of Menards’s expenditures was
reasonably related to the amount of the benefit that Menards
derived.
Petitioners contend that the TMI expenses were “in the range
of what a sponsor/independent-third-party would pay to be a
sponsor of successful cars like those owned by TMI in exchange
for the benefits received by Menards.” In support of their
assertion, at trial, petitioners introduced expert testimony
regarding the value of a race car sponsorship. Respondent
offered a sponsorship valuation expert, but the Court did not
recognize him as an expert for purposes of this case.
a. Petitioners’ Experts
Petitioners’ first expert was John P. Caponigro, president
of Sports Management Network, Inc. (SMN).62 SMN represents
champion race car drivers, among other sports and entertainment
industry personalities, and specializes “in the business side” of
motor sports. SMN’s motor sports marketing and consultation
division, called SMN Motorsports, analyzes, structures, and
negotiates sponsorship programs for the IRL. When valuing
sponsorships, Mr. Caponigro considers factors such as the league
schedule, television coverage and ratings, onsite attendance,
62
Mr. Caponigro has been the president of SMN since the
company’s inception in 1989.
- 76 -
hospitality, merchandising, business-to-business opportunities,
and special events.
For purposes of valuing television exposure, in his expert
report, Mr. Caponigro relied on Indy racing yearend sponsor
reports published by Joyce Julius and Associates, Inc. (Joyce
Julius). According to Mr. Caponigro, Joyce Julius is the “most
prominent” sponsorship reporting service in racing. Joyce Julius
measures and assigns a value to sponsors’ television exposure
during races. The measurement process involves watching
videotapes of the races and recording the frequency and duration
of verbal or visual references to sponsors’ names or logos. In
order to assign a value, Joyce Julius then multiplies the amount
of exposure time by the cost of purchasing an identical amount of
television commercial time.63
The Joyce Julius report for the 1997 IRL season ranked
Menards fifth out of 522 associate, series, and event (AS&E)
sponsors, with an estimated exposure value of $8,457,925. For
the 1998 IRL season, Menards’s estimated exposure value was
$3,518,165, for a sixth-place ranking among a total of 524 AS&E
sponsors.
63
Critics of Joyce Julius reports question whether sponsor
name and logo exposure during races necessarily equates with
television commercial exposure and whether the logos often pass
too fleetingly on screen to make an impression on viewers.
- 77 -
In addition to television exposure, in his expert report,
Mr. Caponigro considered the following factors that he claimed
enhance sponsorship values: (1) The “prestige of participating
in the Indy 500";64 (2) good team performance on a consistent
basis; (3) one or more drivers with “star power”; and (4) the
extent to which a sponsor requires ancillary rights, such as use
of a driver’s name, image, and likeness.
Finally, the business opportunities afforded by sponsorships
may affect the sponsorship’s value. At the races, sponsors
develop business relationships with other participants and learn
about their products and services in a “more personal
environment”. If a sponsor is in business competition with one
or more other participants, the sponsor may spend more on a
sponsorship in order to match the size and scope of its
competitors’ sponsorships.
In his report, Mr. Caponigro also explained the different
levels of sponsorship categories. Mr. Caponigro described
primary sponsors as “usually the most prominent visually or most
important to the program.” The second class of sponsors,
“associate/secondary” sponsors, are “smaller in scope yet still
64
He described the Indy 500 as equal in prominence to the
World Series or the Super Bowl and called it a “Memorial Day
tradition”.
- 78 -
prominent.” Mr. Caponigro estimated that IRL primary and
associate sponsorship values range from $2 million to $20 million
and $100,000 to $5 million, respectively.65
After reviewing the extent of Menards’s involvement with
TMI, Mr. Caponigro classified Menards as a “primary/foundation66
sponsor” for both 1997 and 1998. Mr. Caponigro reached this
conclusion for 1997 even though Glidden had “some graphic
designations and positioning as would a primary sponsor on some
teams” and the Joyce Julius reports categorized Glidden as the
primary or “team” sponsor. According to Mr. Caponigro,
regardless of other sponsor’s logo positioning on the TMI race
65
In his expert report, Mr. Caponigro combined CART with the
IRL to construct these sponsorship value ranges. As a result, we
suspect that the range of values may be exaggerated. CART races
take place all over the world, including races in Europe and
Australia. Additionally, the CART schedule contains more races
than the IRL schedule. According to Mr. Caponigro, the annual
IRL team budgets range from $2 million to $25 million or higher,
whereas the CART budgets range from $5 million to $50 million or
higher. Petitioners’ second expert, Cary J.C. Agajanian, also
indicated that CART teams typically spend more than IRL teams.
Clearly, CART teams compete on a grander scale than the IRL
teams, require more operating funds, and would need more money
from sponsors to help offset the team’s operating costs. We
disagree with Mr. Caponigro’s assertion that CART and the IRL are
similar enough to warrant “frequent comparisons” between the
teams for purposes of valuing an IRL sponsorship. Accordingly,
we disregard as irrelevant the references in his expert report to
CART.
66
According to Mr. Caponigro, a foundation sponsor is the
team’s core sponsor, which maintains a continuous presence.
- 79 -
cars, “it was clear in the racing circles that * * * [the primary
sponsor] was Team Menard.”67
Ultimately, Mr. Caponigro concluded that the range of
reasonable sponsorship fee values for the sponsorship benefits
Menards received in each of the 1997 and 1998 IRL seasons was
between $5 million and $7 million. Mr. Caponigro decided that
this range of values was reasonable based on the sponsorship
benefits Menards received, the general price structure of
comparable arrangements in the industry, the exposure value
Menards derived, and the business advantages available to Menards
through the racing program.
Petitioners’ second expert on sponsorship valuation was Cary
J.C. Agajanian of Motorsports Management International. Over the
last 70 years or more, Mr. Agajanian’s family has been involved
in the ownership of race cars, including Indy cars. Mr.
Agajanian has experience in race promotion, race officiation,
sponsorship contracts, and contracts between drivers and primary
and secondary sponsors. He has “negotiated hundreds of
sponsorship contracts with major corporations for name title
sponsorships, trackside signage, television programming, and
racing vehicles.” During 1997 and 1998, Mr. Agajanian was Tony
67
We assume that, when he made this remark at trial, Mr.
Caponigro meant that Menards, rather than TMI, was the primary
sponsor of TMI.
- 80 -
Stewart’s manager and, in 1998, represented Mr. Stewart in
contract litigation against Mr. Menard.
Like Mr. Caponigro, Mr. Agajanian examined the 1997 and 1998
Joyce Julius yearend sponsor reports on television exposure value
but cautioned that the Joyce Julius reports are intended for
comparisons between brands and do not set firm advertising
values. Moreover, Mr. Agajanian explained, the Joyce Julius
reports do not account for other forms of exposure, including
newspapers, magazines, radio, internet, and racing fans’ brand
loyalty. According to Mr. Agajanian, the “normally accepted
premise” regarding racing media exposure is that television
constitutes 40 percent to 50 percent of total sponsor media
exposure.
Applying the 50-percent premise to Menards’s Joyce Julius
television exposure values for 1997 and 1998, Mr. Agajanian
estimated that Menards’s total media exposure value from its
involvement with TMI was $16,914,000 for 1997 and $7,036,000 for
1998. Mr. Agajanian attributed the difference between Menards’s
exposure values for 1997 and 1998 to Menards’s having more wins
and leading more laps in 1997.
In addition to television exposure, Mr. Agajanian’s report
discussed another factor affecting sponsorship values, the
market-driven nature of sponsorship pricing. He explained that
winning or leading cars gain “millions of dollars of exposure”
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from the live audience and worldwide television and radio
broadcasts of the races and, as a result, charge higher
sponsorship fees. Mr. Agajanian estimated that Indy sponsorship
fees for the competitive teams in the 1997 and 1998 IRL seasons
ranged from $3 million to $6 million per car. For the Indy
teams, in general, during the 1997 and 1998 IRL seasons, Mr.
Agajanian explained, the total fees ranged from $2 million to $10
million per car.
Mr. Agajanian concluded that the amount Menards spent on the
TMI expenses was reasonable, especially when considering TMI’s
“dominant performance” during 1997 and 1998. Assuming that
Menards spent between $5 million and $7 million each year for two
cars, Mr. Agajanian compared that price of $2.5 million to $3.5
million per car to the market price and determined that Menards
“more than received fair value” in exchange for the TMI payments.
b. Value of Sponsorship Benefits Menards Received
Relying on Mr. Caponigro’s and Mr. Agajanian’s expert
reports, petitioners argue that, in light of the media exposure
Menards received through its involvement with TMI and other
advertising benefits, the TMI expenses were reasonable in amount.
However, respondent criticizes the expert reports, calling Mr.
Agajanian’s report “vague and unsupported” and questioning Mr.
Agajanian’s impartiality due to his business relationship with
Mr. Menard. Respondent argues that the experts should have
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compared Menards’s share of sponsorship benefits to the other
sponsors’ shares, for which records of fees paid were available,
and should have clarified whether Menards’s logo placement
affected the value of benefits received. Respondent also points
out that the Joyce Julius reports, relied on by both experts,
classified Glidden as the primary sponsor.
After reviewing both experts’ reports, we find it necessary
to conduct our own examination of the evidence in the record to
properly determine the value of the sponsorship benefits Menards
received. See Malachinski v. Commissioner, 268 F.3d 497, 505
(7th Cir. 2001), affg. T.C. Memo. 1999-182. Mr. Caponigro’s and
Mr. Agajanian’s reports are helpful to the extent that the
reports provide a range of reasonable sponsorship values, explain
the valuation of television exposure, and list the other
variables that contribute to a sponsorship’s value. However,
both reports lack explanations for important assumptions related
to the experts’ conclusions. For example, neither report
discusses the approximate values of the various sponsorship
benefits Menards received or compares the benefits to those
received by other TMI sponsors. “The persuasiveness of an
expert’s opinion depends largely upon the disclosed facts on
which it is based.” Estate of Davis v. Commissioner, 110 T.C.
530, 538 (1998).
- 83 -
For both 1997 and 1998, TMI had more than one major sponsor.
Mr. Menard testified that Quaker State was the primary sponsor of
the Robbie Buhl car in 1997, which assertion is consistent with
the placement of the Quaker State logo on the race car. In 1998,
the same placement and prominence was true of the Johns Manville
logo on Mr. Buhl’s race car and uniform. Additionally, during
1997 and 1998, Glidden’s logo was featured most prominently on
the Tony Stewart car and, in 1997, on Mr. Stewart’s uniform.
Despite the significant exposure Glidden, Quaker State, and
Johns Manville received through logo placement and naming, we
cannot say that, in comparison, Menards’s involvement was smaller
in scope or more akin to an associate sponsorship. We find
persuasive evidence of Menards’s involvement as similar to a
primary sponsor in the inclusion of “Menards” in both race car
names, strategic placement of Menards’s logo on the race car and
drivers’ uniforms, and the prominence of Menards’s name on Indy
promotional materials. Moreover, Menards’s use of its
association with TMI for purposes of Menards’s business is more
consistent with the privileges of a primary sponsor: The TMI
drivers attended store grand openings at which they signed
autographs; TMI provided an Indy car for display at the grand
openings; Menards’s Race to Savings sale ads featured TMI’s Indy
cars and logo, as did Menards’s employees’ uniforms worn for the
- 84 -
sale; and Menards’s guests at the races had access to the garage,
the pits, the track, and the drivers for photos and autographs.
In order to determine what portion of the TMI expenses was
reasonable in amount, we turn to the sponsorship fees TMI’s other
primary sponsors paid. Cf. Gill v. Commissioner, T.C. Memo.
1994-92 (arm’s-length standard of reasonableness based on the
amount the taxpayer’s corporation paid to sponsor an independent
third-party’s racing activities). For the 1997 IRL season,
Glidden and Quaker State paid $1.8 million and approximately $1.5
million, respectively, in sponsorship fees. In addition to
paying a sponsorship fee, Glidden provided TMI with financial
assistance estimated to be worth at least $550,000, which would
increase Glidden’s total sponsorship payment to $2.35 million.
In exchange for their total sponsorship fees, Glidden and Quaker
State received primary sponsorship designations for the Tony
Stewart car and Robbie Buhl car, respectively, and less prominent
logo placement on the car for which they were not designated
primary sponsors.68
For the 1998 IRL season, Glidden paid TMI a sponsorship fee
and provided additional financial assistance for a total of at
least $2.55 million. As in 1997, Glidden received primary
68
Menards likely charged higher sponsorship fees for
Mr. Stewart’s car because, in 1996, Mr. Stewart was named the
Indy 500 Rookie of the Year and the fastest rookie in the history
of the Indy 500.
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sponsorship designation with respect to the Tony Stewart car and
less prominent logo placement on the Robbie Buhl car. The
$200,000 increase from the 1997 sponsorship fee may have been
partly attributable to Tony Stewart’s winning the IRL
Championship in 1997. Because the record does not indicate how
much Johns Manville paid to sponsor the Robbie Buhl car in 1998,
but TMI as a team shared the prestige of the 1997 IRL
Championship win, we assume that the Robbie Buhl car sponsorship
fee increased at least half as much in proportion to the increase
in the Tony Stewart car sponsorship fee. Accordingly, we
attribute a sponsorship fee value of $1,583,333 to Johns
Manville’s primary sponsorship of the Robbie Buhl car.69
On the basis of the record, we conclude that, to the extent
Menards’s payment of the TMI expenses equaled the combined 1997
primary sponsorship fees paid by Glidden and Quaker State and the
combined 1998 primary sponsorship fees paid by Glidden and Johns
Manville, the TMI payments were reasonable in amount and
deductible pursuant to section 162(a). As a result, for TYE
1998, Menards may deduct as advertising expenses a prorated
69
We calculated the value as follows: $200,000/1,800,000 =
.111111; .111111/2 = .055555; .055555 x 1,500,000 = $83,333;
1,500,000 + 83,333 = $1,583,333]
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portion of the 1997 and 1998 primary sponsorship fees equal to
$3,873,611.70
IV. The TMI Expenses as a Constructive Dividend
The amount of TMI expenses that Menards paid during 1998 as
advertising expenses was unreasonable to the extent of
$1,619,918.71 Respondent alleges that this difference (the
excess TMI expenses) was a constructive dividend to Mr. Menard.
Section 61(a)(7) includes dividends in a taxpayer’s gross
income. Section 316(a) defines a dividend as any distribution of
property that a corporation makes to its shareholders out of its
earnings and profits. A constructive dividend may arise “‘Where
a corporation confers an economic benefit on a shareholder
without the expectation of repayment, * * * even though neither
the corporation nor the shareholder intended a dividend.’” Hood
v. Commissioner, 115 T.C. 172, 179 (2000) (quoting Magnon v.
Commissioner, 73 T.C. 980, 993-994 (1980)).
70
We calculated the amount as follows: Step 1: $3,850,000
(1997's fees added together: $2.35M + $1.5M)/12 (months) x 11
(months) (Feb.-Dec. 1997) = $3,529,167; Step 2: $4,133,333
(1998's fees added together: $2.55M + 1,583,333)/12 (months) x 1
(month) (Jan. 1998) = $344,444; Step 3: $3,529,167 + 344,444 =
$3,873,611.
71
We calculated the amount as follows: $5,703,251 (alleged
constructive dividend amount) - $4,083,333 (1998 fees added
together: $2.55M + 1,583,333) = $1,619,918.
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Transfers of property from one corporation to a related
corporation may constitute a constructive dividend to the
corporations’ common shareholder whether or not the shareholder
directly receives any property. See Sammons v. Commissioner, 472
F.2d 449, 451 (5th Cir. 1972), affg. in part, revg. in part on
another ground and remanding T.C. Memo. 1971-145; Gulf Oil Corp.
v. Commissioner, 87 T.C. 548, 565 (1986); Rapid Elec. Co. v.
Commissioner, 61 T.C. 232, 239 (1973); Shedd v. Commissioner,
T.C. Memo. 2000-292. The underlying theory is that the property
passes from the transferor corporation to the common shareholder
and then from the common shareholder to the transferee
corporation as a capital contribution. See Sammons v.
Commissioner, supra at 453; Davis v. Commissioner, T.C. Memo.
1995-283. Ultimately, for constructive dividend treatment, the
transfer must satisfy two tests: (1) The objective distribution
test, and (2) the subjective primary purpose test.
A. The Objective Distribution Test
The objective distribution test examines whether the
transfer caused property to leave the transferor corporation’s
control, permitting the common shareholder to exercise direct or
indirect control over the property through some other
instrumentality, such as the transferee corporation. Sammons v.
Commissioner, supra at 451; Gulf Oil Corp. v. Commissioner, supra
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at 565; Shedd v. Commissioner, supra; Davis v. Commissioner,
supra. According to respondent, because Mr. Menard was the
president and sole shareholder of TMI, he obtained indirect
control over the cash that Menards paid to TMI’s vendors. We
agree with respondent. See Shedd v. Commissioner, supra.
B. The Subjective Primary Purpose Test
The subjective primary purpose test helps distinguish
related corporations’ regular business transactions from
transfers intended primarily to benefit the common shareholder.
Sammons v. Commissioner, supra at 451; Shedd v. Commissioner,
supra. Although some business justification may exist for the
property transfer, if the primary or dominant motivation was to
benefit the common shareholder, and the shareholder received a
direct and tangible benefit, the distribution is a constructive
dividend. See Rapid Elec. Co. v. Commissioner, supra at 239;
Chan v. Commissioner, T.C. Memo. 1997-154; Davis v. Commissioner,
supra; see also Broadview Lumber Co. v. United States, 561 F.2d
698, 704 (7th Cir. 1977) (citing Wilkinson v. Commissioner, 29
T.C. 421 (1957)). Mere incidental or derivative benefits to the
common shareholder will not result in constructive dividend
treatment. Shedd v. Commissioner, supra. “However, where a
corporation’s distribution serves no legitimate corporate
purpose, it must be treated as a constructive dividend to the
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benefitted shareholder.” Id.; see also United States v. Mew, 923
F.2d 67, 68 (7th Cir. 1991).
Respondent contends that Menards’s primary reason for paying
the excess TMI expenses was to benefit Mr. Menard through his
common ownership of Menards and TMI. Without Menards’s payment
of the excess TMI expenses, respondent asserts, Mr. Menard would
have had to contribute additional capital to TMI in order to pay
TMI’s vendors. Furthermore, respondent argues, the record
contains no evidence that Menards’s payment of the excess TMI
expenses constituted some other legitimate business transaction,
such as a loan.
In contrast, petitioners contend that the primary purpose
behind Menards’s payment of the excess TMI expenses was to
benefit Menards. Pointing to TMI’s reported 1998 taxable income
of $5,268,279, petitioners dispute respondent’s contention that
without Menards’s payments, Mr. Menard would have had to
contribute additional capital to TMI. Petitioners also emphasize
that Mr. Menard was not personally obligated to pay the excess
TMI expenses and did not otherwise directly benefit from the
payments.
In applying the subjective test, we first examine the
business purpose for Menards’s payment of the excess TMI
expenses. We held, supra, that the excess TMI expenses were not
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Menards’s ordinary and necessary business expenses. The record
contains no other credible explanation for Menards’s payments.
We conclude, therefore, that Menards’s payment of the excess TMI
expenses was intended to benefit Mr. Menard as the sole
shareholder of TMI.
In addition, the record indicates that Mr. Menard directly
and tangibly benefited from Menards’s payment of the excess TMI
expenses. Although Mr. Menard was not personally liable for the
expenses, Menards’s payments provided TMI additional capital,72
which obviated the need for Mr. Menard to contribute from his
personal resources and enhanced the value of Mr. Menard’s 100-
percent ownership interest. See Lohrke v. Commissioner, 48 T.C.
at 689 (“the payment of a corporation’s expenses is one way to
provide capital”); Davis v. Commissioner, supra.
C. Conclusion
Menards’s payment of the excess TMI expenses resulted in a
constructive dividend from Menards to Mr. Menard. As TMI’s
president and sole shareholder, Mr. Menard exercised indirect
control over the payments. Moreover, the payments lacked a
legitimate business justification and directly benefited Mr.
72
At trial neither party introduced specific evidence on the
adequacy of TMI’s capitalization. Accordingly, we decline to
decide whether TMI required additional capital.
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Menard. Consequently, Mr. Menard is liable for tax on the full
amount of the excess TMI expenses, $1,619,918.
V. Constructive Receipt of Interest Income
Respondent alleges that in 1998 Mr. Menard constructively
received interest income in the amount of $639,302 from loans Mr.
Menard made to Menards. On its tax return for TYE 1998, Menards
deducted the accrued interest but did not issue a check to Mr.
Menard until January 29, 1999. After receiving the check, Mr.
Menard reported the interest income on his 1999 tax return.
Respondent contends that Mr. Menard should have reported the
interest income in 1998 for the following reasons: (1) Menards
had credited the interest income to Mr. Menard’s account, making
it available for Mr. Menard’s use during 1998, and (2) as
president, Mr. Menard had the authority to demand payment of the
accrued interest at any time.
Section 61(a)(4) includes interest in a taxpayer’s gross
income. Section 1.451-2(a), Income Tax Regs., provides:
(a) General rule. Income although not actually reduced
to a taxpayer’s possession is constructively received
by him in the taxable year during which it is credited
to his account, set apart for him, or otherwise made
available so that he may draw upon it at any time, or
so that he could have drawn upon it during the taxable
year if notice of intention to withdraw had been given.
However, income is not constructively received if the
taxpayer’s control of its receipt is subject to
substantial limitations or restrictions. * * *
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Whether a taxpayer constructively received income is a question
of fact. Willits v. Commissioner, 50 T.C. 602, 613 (1968).
According to petitioners’ interpretation of the facts,
although Mr. Menard was the president and controlling shareholder
of Menards and had the power to order Menards to distribute funds
to him, Mr. Menard did not have an unqualified, vested right to
receive the interest in 1998. Petitioners also contend that even
though Menards was financially able to pay Mr. Menard in 1998,
Menards did not set the funds aside for that purpose.
In support of their position, petitioners rely on Jerome
Castree Interiors, Inc. v. Commissioner, 64 T.C. 564 (1975),
affd. without published opinion 539 F.2d 714 (7th Cir. 1976). In
Jerome Castree Interiors, Inc., which involved section 267 and
transactions between related taxpayers, the taxpayer-
corporation’s president and his brother, both cash basis
taxpayers, reported bonuses that had accrued in the preceding
year on their tax returns for the year in which the bonuses were
paid. During the accrual year, the total amount of bonuses to be
awarded had not been allocated among the individual officers.
However, on its tax return for that year, the taxpayer-
corporation, an accrual basis taxpayer, deducted the total bonus
amount. We held in Jerome Castree Interiors, Inc. that the
taxpayer-corporation’s president and his brother did not
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constructively receive their bonuses during the accrual year for
the following reasons: (1) During the accrual year, the
individual bonus amounts due each officer were not entered in the
books and records, credited to the officers’ accounts, or
otherwise set apart for them, and (2) payment of the bonuses was
conditioned on the taxpayer-corporation’s financial status. See
id. at 569-570.
We disagree with petitioners’ assertion that the
circumstances surrounding the accrued interest in this case are
similar to the facts of Jerome Castree Interiors, Inc. Unlike
the taxpayer-corporation in Jerome Castree Interiors, Inc.,
Menards set aside Mr. Menard’s accrued interest during the
accrual year; Menards’s TYE 1998 financial statement reported the
exact amount of interest that had accrued during the year on the
loans payable to Mr. Menard. Another difference between this
case and Jerome Castree Interiors, Inc. is that the record here
contains no evidence of any restrictions placed by Menards on the
payment of the accrued interest. Moreover, Menards’s TYE 1998
financial statement indicated that Mr. Menard’s loans to the
corporation were payable on demand.
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The present case is more similar to Heitz v. Commissioner,
T.C. Memo. 1998-220.73 In Heitz, the taxpayers made loans to a
corporation of which the taxpayer husband was the controlling
shareholder, president, and CEO. An accrual basis taxpayer, the
corporation fully deducted interest on the taxpayers’ loans
during the accrual year. However, because a portion of the
interest was not paid until the following year, the taxpayers,
who used the cash basis method, reported that portion in the year
of receipt. We concluded in Heitz that the taxpayers
constructively received that portion as interest income during
the accrual year. After acknowledging the taxpayer husband’s
authority, as the corporation’s president and CEO, to order
payment of the accrued interest, we based our decision on the
taxpayers’ failure to show that they lacked the right to demand
payment or that the corporation lacked the funds to pay them.
Heitz v. Commissioner, supra; see also Zimco Elec. Supply Co. v.
Commissioner, T.C. Memo. 1971-215.
After examining what little evidence the parties presented
with respect to this issue, we conclude that Menards set apart
73
The taxpayers in Heitz v. Commissioner, T.C. Memo. 1998-
220, did not appeal our decision with respect to the constructive
receipt of interest income. See Exacto Spring Corp. v.
Commissioner, 196 F.3d 833 (7th Cir. 1999).
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the accrued interest, Mr. Menard could have demanded payment of
the interest at any time, and Menards placed no substantial
restrictions or limitations on Mr. Menard’s receipt of the
interest. Mr. Menard constructively received interest income in
1998 and is liable for tax on the full amount of $639,302.
VI. Section 6662(a) Accuracy-Related Penalties for Negligence or
Disregard of Rules or Regulations
If any portion of an underpayment of tax required to be
shown on a taxpayer’s return is attributable to “negligence or
disregard of rules or regulations”, the taxpayer is liable for a
penalty equal to 20 percent of that portion of the underpayment.
See sec. 6662(a) and (b)(1). “Negligence” includes a taxpayer’s
failure to “make a reasonable attempt to comply with the
provisions of * * * [the Internal Revenue Code]” and maintain
adequate books and records or properly substantiate items.
“Disregard” comprises “any careless, reckless, or intentional
disregard”. Sec. 6662(c); sec. 1.6662-3(b)(1) and (2), Income
Tax Regs.
Respondent determined that Menards is liable for a section
6662(a) accuracy-related penalty for the TMI expenses deduction,
and Mr. Menard is liable for a section 6662(a) accuracy-related
penalty for the constructive dividend attributable to Menards’s
payment of the excess TMI expenses and the constructive receipt
of interest income. Pursuant to section 7491(c), respondent must
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produce sufficient evidence indicating that imposition of the
section 6662(a) accuracy-related penalties against an individual
is appropriate. Higbee v. Commissioner, 116 T.C. 438, 446
(2001). Respondent has met this burden of production.74
Petitioners now must demonstrate that respondent’s determinations
are incorrect. Id. at 447.
Petitioners advance three arguments for both Menards and Mr.
Menard against imposition of the section 6662(a) accuracy-related
penalties: (1) Petitioners’ positions had a realistic
possibility of being sustained on the merits; (2) the issues were
complex or technical; and (3) petitioners had reasonable cause
for their positions and assumed them in good faith. We examine
each one of petitioners’ contentions in turn.
A. Petitioners’ First Theory
Section 1.6662-3(a), Income Tax Regs., shields a taxpayer
from the section 6662(a) accuracy-related penalty, if certain
exceptions apply. One exception pertains to taxpayer positions
that are “contrary to a revenue ruling or notice * * * issued by
the * * * [Commissioner] and published in the Internal Revenue
74
The record amply demonstrates, among other things, that
Menards’s record keeping with respect to its payment of TMI’s
expenses was not adequate, that Mr. Menard’s loans to Menards
were payable on demand, that Menards had the financial ability to
pay the accrued interest to Mr. Menard during TYE 1998, and that
Mr. Menard failed to report the accrued interest on his 1998 tax
return.
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Bulletin”. Sec. 1.6662-3(a), Income Tax Regs. The section
6662(a) accuracy-related penalty will not apply to such a
position where the position has a realistic possibility of being
sustained on its merits. Sec. 1.6662-3(a), Income Tax Regs.75
Petitioners have not indicated which revenue ruling or
notice, if any, their positions contradict. Accordingly, we
decline to give this argument further consideration.
B. Petitioners’ Second Theory
Petitioners assert that the “voluminous record” and the
“mandatory national office review” of respondent’s brief
illustrate the complex and technical nature of the issues. For
this reason, petitioners argue, the section 6662(a) accuracy-
related penalties do not apply.
Although we agree with petitioners that the state of the
record in this case suggests that the parties had difficulties
with the issues, we disagree that the three issues for which
respondent determined penalties are actually complex or technical
in nature. Menards’s payments of both the TMI expenses and
interest accrued on Mr. Menard’s loans to the company were
straightforward transactions. We reject petitioners’ argument.
75
Sec. 1.6694-2(b), Income Tax Regs. contains the realistic
possibility standard. See sec. 1.6662-3(a), Income Tax Regs.
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C. Petitioners’ Third Theory
Section 6664(c)(1) provides an exception to the section
6662(a) accuracy-related penalty where the taxpayer shows
reasonable cause for, and that the taxpayer acted in good faith
with respect to, any portion of the underpayment. See also sec.
1.6664-4(a), Income Tax Regs. We determine reasonable cause and
good faith on a case-by-case basis, taking into account all
pertinent facts and circumstances. Sec. 1.6664-4(b)(1), Income
Tax Regs. The most important factor is the extent of the
taxpayer’s effort to assess the proper tax liability. Id.
One application of this exception is to a taxpayer’s
reasonable reliance in good faith on the advice of an independent
professional adviser as to the tax treatment of an item. United
States v. Boyle, 469 U.S. 241, 250 (1985); sec. 1.6664-4(b)(1),
Income Tax Regs. The taxpayer must show that (1) the adviser was
a competent professional who had sufficient expertise to justify
the taxpayer’s reliance on him, (2) the taxpayer provided
necessary and accurate information to the adviser, and (3) the
taxpayer actually relied in good faith on the adviser’s judgment.
See Sklar, Greenstein & Scheer, P.C. v. Commissioner, 113 T.C.
135, 144-145 (1999).
As to the first requirement, respondent has not attacked the
competence or expertise of Mr. Stienessen, petitioners’
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accountant and tax return preparer. Moreover, nothing in the
record suggests that petitioners were not justified in their
reliance on Mr. Stienessen as a competent professional.
We next consider whether petitioners provided to Mr.
Stienessen necessary and accurate information for completion of
petitioners’ tax returns. Except for Mr. Stienessen’s and Mr.
Menard’s general testimony that Mr. Stienessen had necessary and
accurate information, petitioners did not present evidence on
this point.
Although petitioners may have believed that they supplied to
Mr. Stienessen all the information he needed, Mr. Stienessen
clearly did not have necessary and accurate information with
respect to the TMI expenses deduction and constructive dividend
issues. Menards’s books and records did not separately identify
the TMI expenses but, instead, lumped them together with
Menards’s own operating costs. As a result, Mr. Stienessen was
unable to properly assess whether Menards was claiming an
unreasonable amount of the TMI expenses as a deduction and paying
the excess as a constructive dividend to Mr. Menard.
Regarding the constructive receipt of interest income issue,
at trial, Mr. Stienessen testified that he did not report the
interest income on Mr. Menard’s 1998 tax return because Mr.
Menard was a cash basis taxpayer and received the check in 1999.
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Petitioners have not shown, however, that Mr. Stienessen was
aware that Menards placed no substantial restrictions or
limitations on Mr. Menard’s receipt of the interest during TYE
1998. Without knowing what information Mr. Stienessen had when
he prepared petitioners’ returns, we cannot conclude that
petitioners gave him necessary and accurate information for
reporting the interest income.
After concluding that Mr. Stienessen lacked necessary and
accurate information for preparing petitioners’ returns, we need
not decide whether petitioners actually relied in good faith on
Mr. Stienessen’s judgment. Petitioners are liable for the
section 6662(a) accuracy-related penalties for negligence or
disregard of rules or regulations as follows: Menards is liable
with respect to the TMI expenses deduction as disallowed, and Mr.
Menard is liable with respect to the excess TMI expenses
constructive dividend and the constructively received interest
income.
We have considered the remaining arguments of both parties
for results contrary to those expressed herein and, to the extent
not discussed above, find those arguments to be irrelevant, moot,
or without merit.
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To reflect the foregoing,
Decisions will be entered
under Rule 155.
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APPENDIX
Petitioners’ and Respondent’s Experts’ Common Measures of
Comparison Group Companies’ Profitability for TYE 1998
Dr. Hakala’s Measures
Gross Revenue Net Return on Return on
Revenue1 Growth2 Income3 Equity4 Assets5
Menards $3.420 12.7% $0.205 18.8% 14.2%
Home Depot 24.156 23.7 1.160 16.1 10.3
Kohl’s 3.060 28.1 0.141 14.8 8.7
Lowe’s 10.137 17.9 0.357 13.7 6.8
Staples 5.732 27.6 0.168 15.3 6.4
Target 27.757 9.4 0.751 16.7 5.3
Mr. Rowley’s Measures
Net Net Sales Net Return on Return on Return on
Sales6 Growth8 Income9 Avg. Equity10 Beg. Equity11 Avg. Assets12
Menards $3.420 12.7% $0.204 20.6% 22.9% 15.6%
Home
Depot 24.156 23.7 1.160 17.8 19.5 11.3
Kohl’s 3.060 28.1 0.141 19.2 27.3 10.3
Lowe’s 10.137 17.9 0.357 14.8 16.1 7.4
7
Staples 5.181 30.6 0.131 15.1 17.2 6.2
Target 27.757 9.4 0.751 19.6 20.7 5.5
1
Gross revenue is total gross sales in billions, rounded to the nearest
million, before the subtraction of sales costs.
2
Revenue growth is the percent change in gross revenue from the preceding
fiscal year.
3
Net income in billions, rounded to the nearest million, was computed after
taxes.
4
Return on equity equals net income divided by shareholders equity and
multiplied by 100 percent.
5
Return on assets equals net income divided by total assets and multiplied by
100 percent.
6
According to Menards’s financial statements, these numbers are actually gross
sales in billions, rounded to the nearest million.
7
For the values of Staples’s gross revenue, revenue growth, and net income in
TYE 1998, a slight discrepancy existed between Mr. Rowley’s and Dr. Hakala’s expert
reports. Neither party explained the discrepancy.
8
According to Menards’s financial statements, these numbers are actually gross
sales growth.
9
Net income in billions, rounded to the nearest million, was computed after
taxes.
10
Mr. Rowley did not explain how he arrived at these numbers for return on
average equity.
11
Mr. Rowley did not explain how he arrived at these numbers for return on
beginning equity.
12
Mr. Rowley did not explain how he arrived at these numbers for return on
average assets.