In the

United States Court of Appeals
               For the Seventh Circuit

No. 08-2125

M ENARD , INC. and JOHN R. M ENARD , JR.,

                                           Petitioners-Appellants,
                                v.


C OMMISSIONER OF INTERNAL R EVENUE,

                                             Respondent-Appellee.


              Appeal from the United States Tax Court.
           Nos. 673-02, 674-02—L. Paige Marvel, Judge.



     A RGUED JANUARY 5, 2009—D ECIDED M ARCH 10, 2009




 Before E ASTERBROOK, Chief Judge, and P OSNER and
W ILLIAMS, Circuit Judges.
  P OSNER, Circuit Judge. The Internal Revenue Code
allows a business to deduct from its taxable income a
“reasonable allowance for salaries or other compensation
for personal services actually rendered,” 26 U.S.C.
§ 162(a)(1), or, as Treas. Reg. § 1.162-7(a) adds, for “pay-
ments purely for services.” Occasionally the Internal
2                                               No. 08-2125

Revenue Service challenges the deduction of a corporate
salary on the ground that it’s really a dividend. A divi-
dend, like salary, is taxable to the recipient, but unlike
salary is not deductible from the corporation’s taxable
income. So by treating a dividend as salary, a corporation
can reduce its income tax liability without increasing
the income tax of the recipient. At least that was true
in 1998, the tax year at issue in this case. As a result of a
change in law in 2003, dividends are now taxed at a
lower maximum rate than salaries—15 percent, versus
35 percent for salary. 26 U.S.C. § 1(h)(11). This makes
the tradeoff more complex; although the corporation
avoids tax by treating the dividend as a salary, which
is deductible, the employee pays a higher tax.
  But depending on its tax bracket, the corporation may
still save more in tax than the employee pays, and in that
event, if the employee owns stock in the corporation, he
may, depending on how much of the stock he owns, prefer
dividends to be treated as salary. Menards’ tax bracket
in 1998 was, its brief tells us without contradiction, 35
percent. Had the new law been in effect then, the corpora-
tion, if unable to deduct the $17.5 million bonus, would
have paid $6.1 million in additional income tax, while
Mr. Menard, had he received the bonus as a dividend and
thus paid 15 percent rather than 35 percent of it in tax,
would have saved only $3.5 million.
  Even before the change in the Internal Revenue Code,
treating a dividend as salary was less likely to be at-
tempted in a publicly held corporation, because if the
CEO or other officers or employees receive dividends
No. 08-2125                                               3

called salary beyond what they are entitled to by virtue
of owning stock in the corporation, the other share-
holders suffer. But in a closely held corporation, the
owners might decide to take their dividends in the form
of salary in order to beat the corporate income tax, and
there would be no one to complain—except the Internal
Revenue Service.
   The usual case for forbidding the reclassification (for
tax purposes) of dividends as salary is thus that “of a
corporation having few shareholders, practically all of
whom draw salaries,” Treas. Reg. § 1.162-7(b)(1), especially
if the corporation does not pay dividends (as such) and
some of the shareholders do no work for the corporation
but merely cash a “salary” check. A difficult case—which
is this case—is thus that of a corporation that pays a
high salary to its CEO who works full time but is also
the controlling shareholder. The Treasury regulation
defines a “reasonable” salary as the amount that “would
ordinarily be paid for like services by like enterprises
under like circumstances,” § 1.162-7(b)(3), but that is not
an operational standard. No two enterprises are alike
and no two chief executive officers are alike, and anyway
the comparison should be between the total compensation
package of the CEOs being compared, and that requires
consideration of deferred compensation, including sever-
ance packages, the amount of risk in the executives’
compensation, and perks.
  Courts have attempted to operationalize the Treasury’s
standard by considering multiple factors that relate to
optimal compensation. E.g., Haffner’s Service Stations, Inc.
4                                                 No. 08-2125

v. Commissioner, 

, 3-4 (1st Cir. 2003); Eberl’s Claim
Service, Inc. v. Commissioner, 

, 999 (10th Cir.
2001); LabelGraphics, Inc. v. Commissioner, 

,
1095 (9th Cir. 2000); Alpha Medical, Inc. v. Commissioner, 

, 946 (6th Cir. 1999); Rutter v. Commissioner, 

, 1271 (5th Cir. 1988). (Alpha and Rutter each list
nine factors.) We reviewed a number of these attempts in
Exacto Spring Corp. v. Commissioner, 

(7th Cir.
1999), and concluded that they were too vague, and too
difficult to operationalize, to be of much utility. Multifactor
tests with no weight assigned to any factor are bad enough
from the standpoint of providing an objective basis for a
judicial decision, Farmer v. Haas, 

, 321 (7th Cir.
1993); Prussner v. United States, 

, 224 (7th
Cir. 1990) (en banc); Palmer v. Chicago, 

,
1318 (7th Cir. 1986); United States v. Borer, 

, 992
(8th Cir. 2005); multifactor tests when none of the factors
is concrete are worse, and that is the character of most
of the multifactor tests of excessive compensation. They
include such semantic vapors as “the type and extent of
the services rendered,” “the scarcity of qualified employ-
ees,” “the qualifications . . . of the employee,” his “con-
tributions to the business venture,” and “the peculiar
characteristics of the employer’s business.”
  All businesses are different, all CEOs are different, and
all compensation packages for CEOs are different. In
Exacto, in an effort to bring a modicum of objectivity
to the determination of whether a corporate owner/em-
ployee’s compensation is “reasonable,” we created the
presumption that “when . . . the investors in his company
are obtaining a far higher return than they had any
No. 08-2125                                                 5

reason to expect, [the owner/employee’s] salary is pre-
sumptively reasonable.” But we added that the presump-
tion could be rebutted by evidence that the company’s
success was the result of extraneous factors, such as an
unexpected discovery of oil under the company’s land, or
that the company intended to pay the owner/employee
a disguised dividend rather than 

.
The strongest ground for rebuttal, which brings us back
to the basic purpose of disallowing “unreasonable” com-
pensation, is that the employee does no work for the
corporation; he is merely a shareholder. See id.; cf. General
Roofing & Insulation Co. v. Commissioner, T.C. Memo 1981-
667, 15-17 (1981). Other types of evidence that might
rebut the Exacto presumption include evidence of a con-
flict of interest, though we’ll see that such evidence is not
always decisive. Also relevant is the relation between
the executive’s compensation that is challenged and the
compensation of other executives in the company; for
useful discussions see Rapco, Inc. v. Commissioner, 

, 954-55 (2d Cir. 1996), and Elliots, Inc. v. Commissioner,

(9th Cir. 1983).
  Comparison with the compensation of executives of
other companies can be helpful if—but it is a big if—the
comparison takes into account the details of the com-
pensation package of each of the compared executives,
and not just the bottom-line salary. This qualification
will turn out to be critical in this case. For the Tax Court
acknowledged that the presumption of reasonableness
had been established but thought it rebutted by evidence
that corporations in the same business as Menards paid
their CEOs substantially less than Menards paid its CEO.
6                                               No. 08-2125

  Menard, Inc. is a Wisconsin firm that under the name
“Menards” sells hardware, building supplies, and related
products through retail stores scattered throughout the
Midwest. It had 138 stores in 1998 and was the third largest
retail home improvement chain in the United States; only
Home Depot and Lowe’s were larger. It was founded by
John Menard in 1962, and, at least through 1998, the tax
year at issue in this case, he was the company’s chief
executive. (All the evidence in the record concerns his
activities in that year.) Uncontradicted evidence depicts
him as working 12 to 16 hours a day 6 or 7 days a week,
taking only 7 days of vacation a year, working even while
spending “personal time” with his family, involving
himself in every detail of his firm’s operations, and
fixing everyone’s compensation. Under his management
Menards’ revenues grew from $788 million in 1991 to
$3.4 billion in 1998 and the company’s taxable income
from $59 million to $315 million. The company’s rate of
return on shareholders’ equity that year was, according
to the Internal Revenue Service’s expert, 18.8 per-
cent—higher than that of either Home Depot or Lowe’s.
  Menard owns all the voting shares in the company and
56 percent of the nonvoting shares, the rest being owned
by members of his family, two of whom have senior
positions in the company. Like the other executives of
Menards, he is paid a modest base salary but participates
along with them in a profit-sharing plan. In 1998, his
salary was $157,500 and he received a profit-sharing
bonus of $3,017,100, and the Tax Court did not suggest
that there was anything amiss with these amounts. But
the bulk of his compensation was in the form of a “5%
No. 08-2125                                              7

bonus” that yielded him $17,467,800, as a result of which
his total compensation for the year exceeded $20 million.
  The 5% bonus program (5 percent of the company’s net
income before income taxes) was adopted in 1973 by the
company’s board of directors at the suggestion of the
company’s accounting firm, though there is no indication
that the firm suggested a number rather than just advising
the board that Mr. Menard should have his own bonus
plan because of his commanding role in the manage-
ment of the company. The board at the time included a
shareholder who was not a member of Menard’s family
and he voted for the plan, which was still in force in 1998
and so far as we know had not been reexamined in the
interim. That shareholder departed and the board in 1998
consisted of Menard, a younger brother of his who
works for the company, and the company’s treasurer.
  There is no suggestion that any of the shareholders
were disappointed that the company obtained a rate of
return of “only” 18.8 percent or that the company’s success
in that year or any year has been due to windfall factors,
such as the discovery of oil under the company’s head-
quarters. But besides thinking Menard’s compensation
excessive, the Tax Court thought it was intended as a
dividend. It thought this because Menard’s entitlement to
his 5 percent bonus was conditioned on his agreeing to
reimburse the corporation should the deduction of
the bonus from the corporation’s taxable income be
disallowed by the Internal Revenue Service or its Wis-
consin counterpart and because 5 percent of corporate
earnings year in and year out “looked” more like a divi-
dend than like salary.
8                                               No. 08-2125

  These are flimsy grounds. Given the fondness of the IRS
and the Tax Court for a “totality of the circumstances”
approach to determining excessive compensation, it was
prudent (and incidentally not in Menard’s personal
financial interest) for the company to require him to
reimburse it should the IRS successfully challenge the
deduction. Nor does 5 percent of net corporate income
look at all like a dividend. Dividends generally are speci-
fied dollar amounts—so many dollars per share—rather
than a percentage of earnings. E.g., William L. Megginson,
Scott B. Smart & Brian M. Lucey, Introduction to Corporate
Finance 436-37 (2008); Harold Bierman, Jr. & Seymour
Smidt, Financial Management for Decision Making 489
(2003); Angela Schneeman, The Law of Corporations and
Other Business Organizations 320-21 (3d ed. 2002); Erich A.
Helfert, Financial Analysis Tools and Techniques: A Guide for
Managers 122 (2001); Jae K. Shim & Joel G. Siegel, Financial
Management 285 (2000). When earnings fall, dividends
may be cut, but they are cut from one fixed amount to
another rather than made to vary continuously, as a
percentage of earnings would do.
  Paying a fixed (though occasionally altered) dividend
provides the shareholder with a more predictable cash flow
than if the dividend varied directly with corporate earn-
ings, which fluctuate from year to year. It thus reduces the
risk (variance) associated with ownership of common
stock. Moreover, the reason for varying a manager’s
compensation with the company’s profits is to increase his
incentive to work intelligently and hard in order to in-
crease those profits, and that reason has no application to
a passive owner. Although tying compensation to the
No. 08-2125                                              9

market value of the company’s stock is criticized by
some economists because of the many factors besides
managerial effort and ability that influence the price of a
publicly traded stock, stock in Menards is not publicly
traded; probably it is not traded at all.
   The most insignificant factor that the Tax Court thought
indicative of a “concealed” dividend was that Menard’s
5 percent bonus is paid at the end of each year. Well, it
would have to be paid either at the end of the year,
when the earnings for the year are known, or in install-
ments throughout the year. Bonuses are usually paid in
a lump, once a year, often at Christmas, but that would
not be a feasible course for Menards to follow unless it
closed for the following week, because its net income
for the year wouldn’t be determinable until the close of
the last day of the year on which the store was open.
Bonuses are more likely to be paid in single payments at
or near the end of the year than dividends are; dividends
usually are paid quarterly. William A. Rini, Fundamentals
of the Securities Industry 13 (2003).
   The court thought it suspicious that the board of direc-
tors that approved the 5 percent bonus in 1998 was con-
trolled by Menard. But it could not be otherwise, since
he is the only shareholder who is entitled to vote for
members of the board of directors, as he owns all the
voting shares in the company. The logic of the Tax Court’s
position is that a one-man corporation cannot pay its
CEO (if he is that one man) any salary! The Tax Court has
flirted with that strange logic, as we shall see.
  A slightly better candidate for suspicion is that the
board of directors had not sought outside advice on
10                                            No. 08-2125

what appropriate compensation for Menard would be.
But the only point of doing that would have been to
provide some window dressing in the event of a chal-
lenge by the IRS. Menard doubtless has a strong opinion
of what he is worth to his company and would not pay
a compensation consultant to disagree.
  It might seem that since Menards paid no formal divi-
dend at all, some of Mr. Menard’s compensation (and
perhaps that of other executives as well) must be a divi-
dend. But that is incorrect, as noted in the Elliots case
that we cited 

. Many corporations
do not pay dividends but instead retain all their
earnings in order to have more capital. One reason that
publicly held corporations—that is, corporations in
which ownership is diffuse, which may enable managers
to pursue personal goals at the expense of shareholder
welfare—usually do pay dividends is that it helps to
discipline management by making it go outside the
company for money for new ventures, thus forcing it to
convince the capital markets that the ventures are likely
to succeed. That reason for paying dividends has no
application to a corporation like Menards in which there
is an almost complete fusion of management and owner-
ship.
  The main focus of the Tax Court’s decision was not on
the issue of “concealed dividend” (that is, whether the
company was acting in good faith in paying $17.5 million
as a bonus rather than as a dividend); it was on whether
Menard’s compensation exceeded that of comparable
CEOs in 1998—that is, whether it was objectively ex-
No. 08-2125                                                11

cessive, and hence (in part) functionally if not intentionally
a dividend rather than a bonus.
  The CEO of Home Depot was paid that year only
$2.8 million, though it is a much larger company than
Menards; and the CEO of Lowe’s, also a larger company,
was paid $6.1 million. But salary is just the beginning of a
meaningful comparison, because it is only one element of
a compensation package. Of particular importance to
this case is the amount of risk in the compensation struc-
ture. Risk in corporate compensation is significant in two
respects. First, most people are risk averse, and the schol-
arly literature on corporate compensation suggests that
risk aversion is actually an obstacle to efficient corporate
management because managers tend to be more risk
averse than shareholders. Shareholders can diversify the
risk of a particular company by owning a diversified
portfolio, but a manager tends to have most of his finan-
cial, reputational, and “specific human” capital tied up
in his job. Robert Yalden et al., Business Organizations:
Principles, Policies and Practice 698-99 (2008); Lucian
Bebchuk & Jesse Fried, Pay Without Performance: The
Unfulfilled Promise of Executive Compensation 19 (2006);
Lance A. Berger & Dorothy R. Berger, The Compensation
Handbook: A State-of-the-Art Guide to Compensation Strategy
and Design 386-87 (4th ed. 2000); Frank H. Easterbrook &
Daniel R. Fischel, The Economic Structure of Corporate Law
99-100 (1991). (By “specific human capital” economists
mean the earnings that a worker obtains by virtue of skills,
training, or experience specialized to the specific firm
that he is working for.) So the riskier the compensation
structure, other things being equal, the higher the execu-
12                                              No. 08-2125

tive’s salary must be to compensate him for bearing the
additional risk.
   That is not a critical consideration in this case because,
as we said, management and ownership in Menards are
not divorced. But a second significance of risk in a com-
pensation structure is fully applicable to this case. A
risky compensation structure implies that the executive’s
salary is likely to vary substantially from year to
year—high when the company has a good year, low when
it has a bad one. Mr. Menard’s average annual income
may thus have been considerably less than $20 mil-
lion—a possibility the Tax Court ignored. Had the corpora-
tion lost money in 1998, Menard’s total compensation
would have been only $157,500—less than the salary of a
federal judge—even if the loss had not been his fault. The
5 percent bonus plan was in effect for a quarter of a
century before the IRS pounced; was it just waiting for
Menard to have such a great year that the IRS would
have a great-looking case?
  Nor did the Tax Court consider the severance packages,
retirement plans, or perks of the CEOs with whom it
compared Menard (although it did take account of their
stock options), even though such extras can make an
enormous difference to an executive’s compensation. E.g.,
Lucian Arye Bebchuk & Jesse M. Fried, “Stealth Com-
pensation via Retirement Benefits,” 1 Berkeley Bus. L. J. 291
(2004); Phred Dvorak, “Companies Cut Holes in CEOs’
Golden Parachutes—New Disclosure Rules Prompt More
Criticism of Guaranteed Payouts,” Wall St. J., Sept. 15,
2008, p. B4. Just two years after Menard received his
questioned $20 million, Robert Nardelli became CEO of
No. 08-2125                                               13

Home Depot. In his slightly more than six years in that
post he was paid $124 million in salary, exclusive of stock
options; and when fired in 2007 (he was unpopular, and
during his tenure the market capitalization of Home
Depot increased negligibly—only to jump when his
firing was announced), he received a much-criticized
severance payment of $210 million (including the value
of his stock options). He went on to become the CEO of
Chrysler, where he is being paid $1 a year, thought by
some observers to be generous. We wonder whether the
IRS plans to challenge Menard’s compensation for the
years 2001 to 2006, using Nardelli’s compensation
package as a basis for comparison.
  The Tax Court ruled that any compensation paid Menard
in 1998 in excess of $7.1 million was excessive. The
$7.1 million figure was arrived at by the following steps:
(1) Divide Home Depot’s return on investment (16.1
percent) by the compensation of Home Depot’s CEO
($2,841,307). (2) Divide Menards’ return on investment
(18.8 percent) by the result of step (1). (3) Multiply the
result of step (2) ($3,317,799) by 2.13, that being the ratio
of the compensation of Lowe’s’ CEO to that of Home
Depot’s CEO. In words, the court allowed Menard to
treat as salary slightly more than twice the salary he
supposedly would have had if he had been Home
Depot’s CEO and if Home Depot had had as high
a return on investment as Menards did. The judge’s
assumption was that rate of return drives CEO compensa-
tion except for random factors assumed to have the
same effect on Menard’s compensation as it did on that
of Lowe’s’ CEO; for Lowe’s paid its CEO more than twice
14                                            No. 08-2125

as much as Home Depot paid its CEO even though Lowe’s
was a smaller company and its rate of return was lower.
  This was an arbitrary as well as dizzying adjustment. It
disregarded differences in the full compensation packages
of the three executives being compared, differences in
whatever challenges faced the companies in 1998, and
differences in the responsibilities and performance of
the three CEOs.
  We have discussed risk; with regard to responsibilities
there is incomplete information about the compensation
paid other senior management of Menards besides
Mr. Menard himself, and no information about the com-
pensation paid the senior managements of Home Depot
or Lowe’s other than those companies’ CEOs. The rele-
vance of such information is that it might show that
Menard was doing work that in other companies is dele-
gated to staff, or conversely that staff was doing all the
work and Menard was, in substance though not in
form, clipping coupons. The former inference is far more
likely, given the undisputed evidence of Menard’s worka-
holic, micromanaging ways and the fact that Menards’
board of directors is a tiny dependency of Mr. Menard.
He does the work that in publicly held companies like
Home Depot or Lowe’s is done by boards that have
more than two directors besides the CEO. Of course they
are larger companies—Home Depot’s revenues were
seven times as great as Menards’ in 1998—so we would
expect them to have more staff. But we are given
no information on how much more staff they had.
  We know that besides Menard himself, Menards—
already a $3.4 billion company in 1998—had only three
No. 08-2125                                           15

corporate officers. The Tax Court thought it suspicious
that they were modestly compensated—their total compen-
sation in 1998 was only $350,000, and the highest-paid
employee in the company after Menard himself—the senior
merchandise manager—received total compensation of
only $468,000. The Tax Court did not consider the pos-
sibility, which the evidence supports, that Menard really
does do it all himself.
   The Tax Court’s opinion strangely remarks that because
Mr. Menard owns the company he has all the incentive
he needs to work hard, without the spur of a salary. In
other words, reasonable compensation for Mr. Menard
might be zero. How generous of the Tax Court never-
theless to allow Menards to deduct $7.1 million from
its 1998 income for salary for Menard!
  The Fifth Circuit has commented sensibly on the Tax
Court’s belief that owners don’t need or deserve
salaries: “the Tax Court questioned whether an incentive
bonus tied to company performance is needed for an
employee who is also a shareholder. Apparently, the
argument is that such an employee already has sufficient
incentive to make the business successful because as a
shareholder he will receive the profits of the business
anyway. This argument, however, misses the economic
realities of the corporate form as taxed under the
internal revenue code. For compensation purposes, the
shareholder-employee should be treated like all other
employees. If an incentive bonus would be appropriate
for a nonshareholder-employee, there is no reason why a
shareholder-employee should not be allowed to
participate in the same manner. In essence, the
16                                                No. 08-2125

shareholder-employee is treated as two distinct indi-
viduals for tax purposes: an independent investor and
an employee.” Owensby & Kritikos, Inc. v. Commissioner,

, 1328 (5th Cir. 1987); see also Elliotts, Inc. v.

, 716 F.2d at 1248.
  The Tenth Circuit, it is true, remarked in Pepsi-Cola
Bottling Co. v. Commissioner, 

, 182 (10th Cir.
1975), that “due to the identity between the predominant
shareholder and the employee in our case we cannot
accept the applicability of the ‘incentive compensation’
reasoning. Mrs. Joscelyn did not have a lack of such
incentive. As owner of 248 of 250 shares she would profit
from her hard work even without salary compensation. A
bonus contract that might be reasonable if executed with
an executive who is not a controlling shareholder may
be viewed as unreasonable if made with a controlling
shareholder, since incentive to the stockholder to call
forth his best effort would not be needed.” We do not
agree, but we note that the court based its decision on a
comparison between Mrs. Joscelyn’s compensation and
that of executives of other companies, rather than
holding that a controlling shareholder may never receive
a bonus. That would not make good sense. After all,
bonuses do not only, or even primarily, reward motivation;
they reward performance.
  We conclude that in ruling that Menard’s compensation
was excessive in 1998, the Tax Court committed clear
error, and its decision is therefore
                                                   R EVERSED.

                            3-10-09