                  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.
                         - 2 -

     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”
                         - 3 -

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
                                    - 4 -

     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.
                                    - 5 -

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.
                              - 6 -

     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.
                              - 7 -

     (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...)
                                - 8 -

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.
                                 - 9 -

     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.
                                 - 10 -

            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),
                                     - 11 -

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...)
                               - 12 -

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.
                               - 13 -

      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.
                                 - 14 -

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.
                                - 15 -

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
                                 - 16 -

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
                                 - 17 -

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.
                                 - 18 -

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...)
                              - 19 -

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.
                                 - 20 -

     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
                               - 64 -

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
                               - 65 -

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.
                                 - 67 -

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.
                                - 69 -

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.
                                - 70 -

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
                                - 71 -

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...)
                                - 72 -

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”
                               - 81 -

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
                               - 82 -

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.
                              - 85 -

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]
                               - 86 -

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.
                              - 87 -

     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
                               - 88 -

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
                               - 89 -

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
                               - 90 -

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.
                                - 91 -

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. * * *
                                - 92 -

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
                               - 93 -

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.
                               - 94 -

     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).
                               - 95 -

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
                                - 96 -

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.
                                - 97 -

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.
                                - 98 -

     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’
                              - 99 -

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.
                              - 100 -

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.
                        - 101 -

To reflect the foregoing,


                                   Decisions will be entered

                              under Rule 155.
                                              - 102 -

                                             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.
