One of the most contested areas in corporate tax is whether a payment to a shareholder‑employee is really a dividend in disguise. If it’s reasonable compensation, the corporation deducts it under § 162(a)(1) and the employee pays tax once. If it’s excessive, the portion over reasonable compensation may be treated as a nondeductible dividend.
In Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009), Judge Posner reviewed the history of this dispute. Mr. Menard, founder and CEO of a hardware chain, worked 12‑16 hours a day, six or seven days a week, and received total compensation over $20 million, including a bonus tied to company profits.
The Seventh Circuit adopted a presumption of reasonableness when the investors in a company are “obtaining a far higher return than they had any reason to expect.” Id. at 839. That presumption can be rebutted by evidence that the employee does no real work or that the compensation is a disguised dividend. Applying that standard, the court reversed the Tax Court, holding that Menard’s compensation was reasonable.
The court stressed that a controlling shareholder is not automatically disqualified from receiving a bonus; bonuses reward performance, not just motivation.
Here’s the practical takeaway: Document the reasons for executive compensation, compare it to industry standards, and ensure the executive actually performs valuable services. A board resolution approving the compensation – especially if independent directors are involved – can go a long way.
This article is for general informational purposes only and is subject to change. Tax laws are complex and vary by situation. You should consult a qualified professional for advice specific to your circumstances. For questions, contact Alan Goldstein.
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