John Menard's Tax Crackup

When the home improvement magnate paid himself $20 million, the IRS slapped him -- hard. If your salary is too high, you could be next.

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As you're getting your taxes ready, here's a number to keep in mind: $15 million.

That's the amount a tax court recently decided that Menard Inc. had improperly deducted from its corporate tax return in 1998, the year it was audited by the IRS. As the court saw it, the home improvement chain, based in Eau Claire, Wis., had grossly overpaid its founder and CEO, John Menard, and then taken far too big a deduction for his salary. The court also slapped the privately held company for the way it mishandled certain business expenses.

Here's another number to consider: $443 million. That's how much the IRS budget is supposed to increase in fiscal 2006 if President Bush has his way. It's an overall budget boost of 4.3%, though enforcement activities -- audits, investigations, and the like -- are slated for an increase of 7.8%. The IRS also recently announced plans to reverse its yearslong decline in small-business audits and enforcements, says IRS commissioner Mark Everson.

Could this mean that you're in for an audit -- and perhaps a multimillion-dollar fine as well? It'll be far less likely if you learn from John Menard, whose case provides a textbook example of what not to do when filing corporate taxes. To be sure, Menard is no ordinary entrepreneur. With about 200 stores stretching across the Midwest, he is one of the richest men in Wisconsin. Nor is this his first brush with the authorities (See "Sales Are Up. So Are Lawsuits," page 20). But the issues that emerged from his audit are pretty common, says Emily Parker, former deputy chief counsel at the IRS and now a partner with Thompson & Knight LLP in Dallas.

The Feds have always been extremely interested in how executives are compensated. That's because while corporations must pay taxes on dividends, they can deduct salaries (including bonuses) as expenses. As a result, the IRS casts a wary eye at business owners who pay themselves, or their top execs, outsize salaries or bonuses but pay no dividends -- especially when the company is profitable. Indeed, authorities are inclined to see large salaries as "disguised dividends," says G. Michelle Ferreira, tax attorney at Greenberg Traurig in Silicon Valley.

Menard Inc., with 2004 revenue of some $6 billion, has never paid a dividend. What's more, the bulk of John Menard's compensation came in the form of an annual bonus, pegged at 5% of the company's profit. In 1998, that sum was $17.5 million, part of a total compensation package worth $20.6 million. To the IRS, any bonus that's tied to profit and paid out once a year smells suspiciously like a dividend. Adding to the suspicion was the fact that Menard's salary had been set by the company's three-person board -- which consisted of Menard, his brother, and the company's CFO.

Menard found himself in even more trouble when the court set out to determine what constituted a reasonable salary. As it happened, the CEO of Home Depot earned just $2.8 million in 1998 and the CEO of Lowe's about $6 million -- even though both chains are larger than Menard's. Because Menard had a higher return on equity, however, the judge found Menard's salary should be $7 million. Which meant that the company had improperly deducted $13 million of his salary, failing to pay taxes on it as a dividend.

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