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.
Disguised dividends aren't just an issue for millionaires, says Ferreira. In a 2004 case, for instance, a business owner paid himself a salary of $420,000 and deducted it as a business expense; with the help of that deduction, his company paid less than $3,000 in corporate taxes that year. After auditing the return, however, the IRS decided that his salary should have been a more modest $77,000, forcing the company to pay more than $300,000 in taxes and penalties. "When the IRS is auditing a corporation, it looks to see if the expenses are grossly out of whack with profits," says Ferreira. "Salaries are one of the first places it'll check out."
Audits of closely held corporations also scrutinize business expenses. Menard ran into trouble here, too. In 1992, Menard, an avid auto racer, founded Team Menard Inc., or TMI, which owns and races Indy and NASCAR cars. TMI was supposed to operate independently from the home improvement chain, but its books were not kept separately. Instead, TMI's expenses were paid out of Menard's coffers -- expenses that Menard then deducted on its corporate tax return. The IRS didn't much care for this arrangement, arguing that the $6 million paid by Menard to TMI in 1998 was an improper deduction and should be disallowed.
Business expenses, of course, are perfectly legal when they're deemed to be "ordinary and necessary." Fortunately for Menard, the court reasoned that some of the payments to TMI were proper. After all, the home improvement chain did receive a promotional boost by having its name emblazoned on the sides of TMI's racecars. But because there was no formal sponsorship agreement between the two entities, it was up to the court to decide how much of the $6 million expense was legit. The decision: $4.4 million. Between Menard's salary woes and expensing problems, the company could end up owing almost $6 million in back taxes and penalties. And there are reportedly seven more audits pending against the company, which could raise the stakes considerably.
The court handed down its first decision on these matters in September 2004. Menard appealed, and the decision was upheld by an appellate court in January. The company, which did not return repeated phone calls for comment, reportedly plans another appeal.
Considering Menard's recent travails and the proposed boost in the IRS budget, how fearful should other business owners be? Well, here's a final number that might help you feel a bit less spooked: 535. That's the number of members of Congress who will get their paws all over the President's proposed budget in the months ahead. And veteran Washington watchers know that proposed increases for the IRS almost never materialize. In previous years, for example, Congress has passed legislation mandating pay increases for IRS staff, leaving the agency without the resources to increase enforcement. Still, it doesn't mean that you should take your chances. There's never a good time to tempt fate and tangle with the IRS. Just ask John Menard.