Judge Posner takes on the IRS again in a case that goes to the heart of the meaning of "reasonable compensation." In the case the IRS challenged the $20 million compensation of Menard's CEO,John Menard. Over $17 million of this amount was the result of a bonus equal to 5% of the company's net income before taxes; a bonus plan that had been in place since 1973! Menard's is presumably a C corporation (the opinion does not say) with Mr. Menard owning must of the stock (all of the voting stock and 56% of the non-voting stock). In such a case, a corporation and its dominate shareholder can benefit from treating compensation as salary (deductible by the corporation) rather than dividends; especially in 1998, the year at issue and before the 2003 tax rate reduction of dividends to 15%.
The IRS challenge was successful at the tax court where the judge disallowed all but about $7 million of the salary (after comparisons to Home Depot and Lowe's CEO salaries). Judge Posner and the 7th Circuit reversed on the grounds that the IRC Section 162(a)(1) test for "reasonable compensation" must be related to the performance of the CEO vis a vis the success of the corporation. You can read the opinion here: http://tinyurl.com/dmrh9z
Now for the S corporation connection for which I thank Maryland tax guru, Stuart Levine, without whom I probably would have missed it. If CEO compensation in the form of salary must be related to the performance of the corporation, those who "play fast and loose with respect to S corps and FICA" (in the words of Levine) should be careful, because it implies that paying such CEOs a low salary to avoid FICA tax and instead reward them with dividends may run afoul of the concept of "reasonable compensation."