                           T.C. Memo. 2005-3



                        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 January 6, 2005.



     Robert E. Dallman, Vincent J. Beres, and Robert J. Misey,

Jr., for petitioners.

     Christa A. Gruber, J. Paul Knap, and Michael Calabrese, for

respondent.




     *
      This opinion supplements our previously filed opinion in
Menard, Inc. v. Commissioner, T.C. Memo. 2004-207.
                               - 2 -

                  SUPPLEMENTAL MEMORANDUM OPINION


     MARVEL, Judge:   On October 14, 2004, we received and filed,

pursuant to Rule 161,1 petitioners’ motion for reconsideration of

our Memorandum Opinion in Menard, Inc. v. Commissioner, T.C.

Memo. 2004-207 (Menard I).   Petitioners’ motion for

reconsideration requests that we reconsider two parts of Menard

I:

     (1) Our conclusion that John R. Menard’s (Mr. Menard)

compensation for the taxable year ended (TYE) 1998 was not paid

by Menard, Inc. (Menards), purely for Mr. Menard’s services;

     (2) our ruling that part of Exhibit 17-J, summarizing the

compensation of Menards’s officers for years before TYE 1991, is

not admissible.

     With respect to (1), petitioners contend that we

misinterpreted the opinion of the Court of Appeals for the

Seventh Circuit in Exacto Spring Corp. v. Commissioner, 196 F.3d

833 (7th Cir. 1999), revg. Heitz v. Commissioner, T.C. Memo.

1998-220,2 in deciding whether the compensation paid to Mr.


     1
      All Rule references are to the Tax Court Rules of Practice
and Procedure, and all section references are to the Internal
Revenue Code in effect at all relevant times.
     2
      This case is appealable, barring a stipulation to the
contrary, to the Court of Appeals for the Seventh Circuit. We
are obligated by Golsen v. Commissioner, 54 T.C. 742 (1970),
affd. 445 F.2d 985 (10th Cir. 1971), to apply the independent
investor test articulated by the Court of Appeals in Exacto
                                                   (continued...)
                               - 3 -

Menard during TYE 1998 was purely for services, as required by

section 162 and section 1.162-7(a), Income Tax Regs.   Petitioners

argue that Exacto Spring Corp. eliminated the multifactor test

not only for testing whether the compensation was reasonable but

also for testing whether the compensation was paid purely for

services and that it substituted a bad faith standard for

determining whether compensation was paid purely for services.

     With respect to (2), petitioners contend that all of Exhibit

17-J is relevant and that we made factual findings inconsistent

with our ruling excluding information in Exhibit 17-J dealing

with years before TYE 1991.3   Petitioners allege that we must

have relied on the excluded part of Exhibit 17-J to find certain

facts and that we should revisit our ruling to correct the

mistake.

     This Supplemental Memorandum Opinion rejects petitioner’s

contentions for the reasons set forth below.

                           Background

     We adopt the findings of fact in Menard I.   For convenience

and clarity, we repeat below the previously found facts necessary




     2
      (...continued)
Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), revg.
Heitz v. Commissioner, T.C. Memo. 1998-220.
     3
      Our ruling with respect to Exhibit 17-J is set forth in n.4
of Menard I.
                               - 4 -

for the disposition of this motion, and we supplement those

findings with additional facts as appropriate.

     Menards is an accrual basis taxpayer and has a fiscal year

ending January 31 for tax and financial reporting purposes.

Menards timely filed Form 1120, U.S. Corporation Income Tax

Return, for TYE 1998 on which it reported $3.42 billion of gross

revenue and $315,326,485 of taxable income.

     Menards was incorporated in 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.

     During TYE 1998, Mr. Menard, the controlling shareholder of

Menards, served as its president and chief executive officer

(CEO).   Mr. Menard’s compensation for TYE 1998 consisted of the

following:

                  Item                             Amount

           Base salary
             (regular weekly payroll)              $62,400
           Base salary
              (paid in December)                    95,100
           5-percent bonus                      17,467,800
           Instant Profit Sharing                3,017,100
           Christmas gift bond                         185
              Total                             20,642,585

     By comparison, the CEOs of Menards’s two closest competitors

received compensation in TYE 1998 as follows:
                              - 5 -

                 Company                Compensation

               Home Depot               $2,841,307
               Lowe’s                    6,054,977

For TYE 1998, both Home Depot and Lowe’s had substantially

greater gross revenue, revenue growth, and net income than

Menards, but Menards had the highest return on equity and return

on assets of the three companies.

     After applying the independent investor test established by

the Court of Appeals for the Seventh Circuit in Exacto Spring

Corp. v. Commissioner, supra, and after considering evidence of

CEO compensation paid by comparable companies as required by

section 1.162-7(b)(3), Income Tax Regs., we concluded that

Menards’s rate of return on equity was sufficient to create a

rebuttable presumption that Mr. Menard’s compensation for TYE

1998 was reasonable in amount but that the presumption of

reasonableness was rebutted by evidence drawn from comparable

companies that Mr. Menard’s compensation was not reasonable.

After evaluating the evidence, we held that Mr. Menard’s salary

for TYE 1998 was reasonable to the extent of $7,066,912 and

allowed Menards a deduction for that amount.

     As an alternative basis for our decision, we decided whether

Mr. Menard’s compensation was payment purely for services

rendered or was instead a disguised dividend.   In Exacto Spring

Corp. v. Commissioner, supra at 835, the Court of Appeals for the

Seventh Circuit stated that the “primary purpose of section
                                - 6 -

162(a)(1)” is to prevent corporations from disguising dividends

as salary.   The Court of Appeals 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

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 must be decided on the

basis of the facts and circumstances.      E.g., Paula Constr. Co. v.

Commissioner, 58 T.C. 1055, 1059 (1972), affd. without published

opinion 474 F.2d 1345 (5th Cir. 1973).     After reviewing the

relevant facts and circumstances, we concluded that a portion of

Mr. Menard’s salary (the amount in excess of $7,066,912) was not

paid purely for services.    In support of our conclusion, we

emphasized several facts.    Menards, a closely held corporation,

had never paid a dividend.    Menards’s board of directors awarded

Mr. Menard a bonus equal to 5 percent of Menards’s net income

before taxes without making any effort to evaluate whether the

bonus, combined with other components of Mr. Menard’s

compensation, would result in the payment of excessive and

unreasonable compensation.    The 5-percent bonus was paid pursuant
                                - 7 -

to a formula and was subject to a reimbursement agreement that

required Mr. Menard to reimburse Menards if any portion of the

bonus was disallowed as a deduction.     For TYE 1998, the formula

resulted in a bonus that, when added to Mr. Menard’s other

compensation, substantially exceeded the compensation paid to

CEOs in comparable companies.

      Petitioners timely filed a motion for reconsideration of our

opinion.   In the motion, petitioners (1) challenged our

evidentiary ruling excluding, as irrelevant, the portion of

Exhibit 17-J that summarized Menards’s officer compensation for

taxable years ended before 1991 and (2) challenged our

application of the “purely for services” prong of the section 162

test for the deductibility of compensation.    In support of their

motion, petitioners argued, with respect to Exhibit 17-J, that

“other tax years may be relevant to the years in issue by showing

a pattern of behavior.”   With respect to the “purely for

services” prong of the section 162 test, petitioners argued that

the holding of the Court of Appeals for the Seventh Circuit

“requires a finding of bad faith by the taxpayer and there has

been no bad faith in this case.”

                            Discussion

I.   Admissibility of Excluded Portion of Exhibit 17-J

      Petitioners argue that information regarding Menards’s

officer compensation for taxable years ended before 1991 may be
                                 - 8 -

relevant as part of a “continuing pattern of activity”, but they

do not explain how the information has any relevance to the two-

prong test for evaluating the deductibility of compensation under

section 162.

      The Court of Appeals for the Seventh Circuit in Exacto

Spring Corp. v. Commissioner, 196 F.3d 833 (7th Cir. 1999), has

made it abundantly clear that we must use the independent

investor test to ascertain whether a CEO’s compensation is

reasonable in the first instance.     Under the independent investor

test, 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.   That presumption 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 performed by someone else.     Id.   In

Menard I, we concluded that the presumption could also be

rebutted by evidence that comparable publicly traded corporations

paid substantially less compensation to their CEOs than the

amount paid by a closely held corporation, and we held that the

presumption of reasonableness that attached to Mr. Menard’s TYE

1998 compensation had been rebutted by evidence that his
                               - 9 -

compensation greatly exceeded the compensation paid by Menards’s

chief competitors to their CEOs.

     As respondent points out in his response to petitioners’

motion, petitioners make no attempt to explain why evidence of

Mr. Menard’s compensation for taxable years ended before 1991 has

any relevance to our analysis under the independent investor test

established in Exacto Spring Corp.     The independent investor test

focuses on the rate of return on equity for the year the

compensation is paid.   The presumption of reasonableness created

by a qualifying rate of return is rebutted either by evidence

that something other than the CEO’s services generated or

contributed to that year’s rate of return or by evidence that the

marketplace considered the CEO’s compensation for that year to be

unreasonable.   Petitioners have failed to explain how evidence of

Mr. Menard’s compensation in taxable years ended before 1991 is

relevant to any aspect of the independent investor test.

Petitioners also failed to present any argument regarding why

this evidence is relevant to the “purely for services” prong of

the section 162 test for deducting compensation.

     The burden of demonstrating an exhibit’s relevance is on the

party seeking its admission.   Dowling v. United States, 493 U.S.

342 (1990).   Moreover, a court has broad discretion to determine

the admissibility of evidence based on remoteness in time.     Keyes

v. School Dist. No. 1, 521 F.2d 465, 473 (10th Cir. 1975).    The
                               - 10 -

parties stipulated that compensation information for TYE January

31, 1991, to January 31, 1998, was admissible, and, in accordance

with the parties’ stipulation, we admitted that part of Exhibit

17-J containing compensation information for those years.

Respondent points out that the issue is not whether historical

compensation information is or might be relevant; the issue is

how much historical compensation information is admissible.

Petitioners have not shown that the ruling excluding that part of

Exhibit 17-J containing compensation information for taxable

years ended before January 31, 1991, is an abuse of our

discretion.

     In support of their argument, petitioners contend that we

relied in Menard I on the unadmitted part of Exhibit 17-J.    In

their motion, petitioners focus on two factual statements in

Menard I.    The first is that Mr. Menard has received an annual

bonus since 1973, slip op. at 12, and the second is that the 5-

percent bonus generally increased each year, slip op. at 63.

Petitioners link the two statements together and claim that the

Court must have relied on the unadmitted part of Exhibit 17-J to

make them.    Petitioners’ claim is inaccurate.   Our statement that

Mr. Menard has received an annual bonus since 1973 is supported

by Exhibit 16-J, by the uncontroverted testimony of Al Pitterle,

and by paragraph 44 of the stipulation of facts.    Our statement

that the 5-percent bonus “generally increased each year” is
                              - 11 -

supported by the admitted part of Exhibit 17-J, which indicated

that Mr. Menard’s compensation and his 5-percent bonus generally

increased each year from TYE January 31, 1991, through January

31, 1998.

      Because petitioners have failed to demonstrate (1) that

compensation information for taxable years ended before January

31, 1991, is relevant and (2) that we relied on the unadmitted

portion of Exhibit 17-J contrary to our ruling, we reject

petitioners’ arguments with respect to Exhibit 17-J.

II.   Bad Faith

      Petitioners’ argument that Exacto Spring Corp. imposes a

“bad faith” requirement for determining whether compensation is a

disguised dividend is derived entirely from a single statement in

that opinion:

      The fact that * * * [the president/shareholder’s salary
      at issue] was approved by the other owners of the
      corporation, who had no incentive to disguise a
      dividend as salary, goes far to rebut any inference of
      bad faith here, which in any event the Tax Court did
      not draw and the government does not ask us to draw.

Exacto Spring Corp. v. Commissioner, 196 F.3d at 839.

Petitioners conclude from the above-quoted statement that the

Court of Appeals for the Seventh Circuit rejected the multifactor

test for both prongs of the section 162 compensation test and

that the Court of Appeals now requires a showing of bad faith

before we can conclude that compensation was not paid purely for

services.
                                - 12 -

     We reject petitioners’ argument.    We cannot discern any

intention on the part of the Court of Appeals to incorporate a

bad faith requirement into the analysis of whether compensation

is paid purely for services.    The Court of Appeals in Exacto

Spring Corp. referenced the two-prong test under section 162 and

stated that deductible compensation under section 162 must be

both reasonable in amount and a payment purely for services.     Id.

at 839.   In addressing the hypothetical case of a CEO who

rendered no services to his company yet received a substantial

salary, the Court of Appeals stated as follows:

     The multi-factor test would not prevent the Tax Court
     from allowing a deduction in such a case even though
     the corporation obviously was seeking to reduce its
     taxable income by disguising earnings as salary. The
     court would not allow the deduction, but not because of
     anything in the multi-factor test; rather because it
     would be apparent that the payment to the employee was
     not in fact for his services to the company. Treas.
     Reg. §1.162-7(a); * * *.

Id. at 835.

The Court of Appeals did not reject section 1.162-7, Income Tax

Regs.   Instead, as evidenced by the above quotation, the Court of

Appeals cites and relies on it for the proposition that

compensation that is not paid purely for services is not

deductible under section 162.

     Section 1.162-7(b)(1), Income Tax Regs., speaks specifically

to the “purely for services” prong of the test under section 162.

It states as follows:
                              - 13 -

     Any amount paid in the form of compensation, but not in
     fact as the purchase price of services, is not
     deductible. An ostensible salary paid by a corporation
     may be a distribution of a dividend on stock. This is
     likely to occur in the case of a corporation having few
     shareholders, practically all of whom draw salaries.
     If in such a case the salaries are in excess of those
     ordinarily paid for similar services and the excessive
     payments correspond or bear a close relationship to the
     stockholdings of the officers or employees, it would
     seem likely that the salaries are not paid wholly for
     services rendered, but that the excessive payments are
     a distribution of earnings upon the stock. * * *

As respondent points out, there is nothing in Exacto Spring Corp.

to indicate that the Court of Appeals now requires a finding of

bad faith to support a conclusion that some part of an

executive’s salary is not purely for services or that the Court

of Appeals has rejected section 1.162-7(b)(1), Income Tax Regs.

(fact that salaries are higher than those ordinarily paid for

similar services is evidence that the salaries are probably not

paid solely for services rendered).

     Payments to employee/shareholders of closely held

corporations merit strict scrutiny.    Exacto Spring Corp. v.

Commissioner, 196 F.3d at 838; Dexsil Corp. v. Commissioner, 147

F.3d 96 (2d Cir. 1998), remanding T.C. Memo. 1995-135; sec.

1.162-7(b)(1), Income Tax Regs.   Mr. Menard owned directly 100

percent of the voting stock and 56 percent of the nonvoting stock

of Menards.   The only other shareholders were primarily members

of his family or trusts established for the benefit of Mr. Menard

and family members.   The majority of Menards’s board of directors
                              - 14 -

in TYE 1998 were family members.   From its incorporation in 1973

through and including TYE 1998, Menards had never paid a

dividend.   Petitioners have failed to convince us that a finding

of bad faith is required before we can decide that a portion of

Mr. Menard’s compensation was not paid purely for his services as

CEO.

III.   Conclusion

       For the above-described reasons, we shall deny petitioners’

motion for reconsideration.


                                         An appropriate order

                                    denying petitioners’ motion

                                    for reconsideration will be

                                    issued.
