Originally Published MX July/August 2004
BUSINESS PLANNING & TECHNOLOGY DEVELOPMENT
IRS Targets Executive CompensationEmployers can protect themselves by reviewing their compensation programs for compliance with current tax laws and consistency with the company's goals.
Ted Ginsburg
Following the recent wave of scandals at publicly traded corporations, the U.S. government's crackdown on corporate governance is heating up. The Internal Revenue Service (IRS) recently announced that it is embarking on a new audit initiative focused on executive compensation. While this new program deals with a very visible area of business, the agency's scrutiny should cause both employers and executives to more closely examine the types of compensation programs that are available.
This article will discuss why the IRS is looking at executive compensation, what areas the agency is (and is not) reviewing, and what employers can do to minimize their chances of being audited.
Why Now?
The IRS is targeting executive compensation programs with a new level of scrutiny for several reasons. First, as a result of the tremendous increase in the complexity of executive compensation programs during the last decade, the IRS is concerned that tax reporting of certain executive benefits is incorrect. Second, the agency is questioning whether executives properly reflect what they receive from their corporation on IRS Form 1040—an inquiry that appears to be related to several popular tax-avoidance schemes.
The IRS is also reacting to public and congressional outrage over excessive executive compensation practices—a subset to the growing litany of corporate scandals. Fraudulent accounting practices and improper business dealings led Congress to enact the statutory changes embodied in the Sarbanes-Oxley Act of 2002, and have also led to the creation of new exchange registration rules for publicly traded companies.
This groundswell of public opinion also resulted in changes to the taxation of certain executive benefits. Those changes became effective with the 2003 tax year. Consequently, the IRS is now interested in whether the new guidance is being followed.
Initial Findings
At an American Bar Association Tax Section meeting in January, a senior IRS official briefly discussed the results of the agency's review of the first few companies selected in the audit program.1 The IRS discovered that an alarming number of corporate executives failed to file their personal income tax returns. Additionally, the IRS found several examples of executives using the company as a "piggy bank," and found other (unidentified) examples of problems and abuses in the executive compensation area.
These initial findings demonstrate that the IRS will likely continue this program and expand its examination of this politically charged area (see sidebar).
Although the IRS has the ability to deny corporate tax deductions for unreasonable compensation, it will not review the absolute levels of compensation received by an executive. According to Keith Jones, director of field specialists for the large and midsized business division of the IRS, the issue of excessive executive pay is not an income tax matter but "is clearly a corporate governance (issue)."2 Additionally, the IRS will not look at the size of supplemental retirement plan payments or severance payments made to departing executives.
How the Review Works
Currently, the IRS is examining the corporate income tax returns of at least 24 companies across the country. The examination is being conducted separately from any other IRS audit of the employer. This is a departure from prior IRS procedure, which provided a cursory review of executive compensation as part of a general tax audit. To ensure that the examination covers every geographic region and major industry group, the IRS was attentive to the industries and headquarters locations of the entities chosen for audit.
Further, the agency has prepared detailed examination programs and given agents special training in executive compensation. After the 24 examinations are concluded, the IRS will make adjustments to its audit programs, train additional agents, and expand its scope of examination to other employers around the country.
The IRS will also ask employers to provide copies of their executives' tax returns. This review, which will extend beyond the top five officers of the employer as stated in SEC filings, seeks to determine if the executives properly reported the income attributable to their employment. This is a sensitive issue for employers, who do not normally obtain copies of their executives' tax returns and have no responsibility for the contents of those personal returns. Employers, therefore, must find a way to convince executives (or former executives) to allow the IRS to review their tax returns. It is possible that the agency could retrieve copies of recalcitrant executives' returns by other means, but that would significantly slow down the audit process—a result that neither the IRS nor employers would want to occur.
How Employers Can Prepare
As described below, there are a number of steps that employers can take in advance to reduce the discomfort that may arise if the audit does occur. These steps should involve human resources, payroll, and tax departments or outside tax preparers. If questions arise, additional tax and legal expertise may be necessary. Many of the steps listed below are good business practice, and may already be occurring in an informal way.
Determine Areas of Concern. A first step is to determine what tax years are open to examination by the IRS (the time frame could be as few as the last three years). Once this is established, a review of specific corporate activities during the period will determine if the employer was engaged in practices that warrant further investigation by the agency. Examples may include the following.
- A split-dollar life insurance program maintained by the employer.
- A change of control by the employer that triggered golden-parachute payments.
- Evidence that executives transferred stock or stock options to family limited partnerships.
- Evidence that executives entered into employee leasing arrangements with the employer.
Identify Other Programs. Many medical device companies maintain a number of executive compensation plans and programs; some will be formalized (such as deferred compensation plans), and some may not (such as cellular phone reimbursement). If a company has grown by acquisition or merger, there may be programs that are still in effect for executives of the prior firms (known as legacy programs). All of these programs should be inventoried and identified in a detailed list (see sidebar).
Monitor Payroll Department Practices. Using the detailed list of compensation programs, the payroll department should indicate how it treats those items. Among the relevant issues are whether the items are reportable on the W-2 form (and if so, whether they were reported); how reportable amounts are calculated; and whether federal income tax, FICA, and Medicare taxes are properly withheld.
The IRS has the authority to impose significant penalties for failure to report or withhold necessary taxes. It is likely that the IRS may find issues of concern in the area of taxable fringe benefits, particularly automobile allowances and relocation expenses.
Examine Corporate Tax Returns. The areas of concern indicated above require specific disclosures (on a corporate income tax or retirement plan return) concerning leased employees, or areas of executive compensation that have had their tax treatment changed in the last two years (e.g., split-dollar life insurance). The IRS will be interested in the timing of corporate deductions related to some compensation programs, particularly those related to nonqualified deferred compensation and stock-based compensation.
Many companies already have procedures in place to enforce the rules relating to the deductibility of compensation in excess of $1 million, and it is likely that the IRS will not probe very deeply into this area.
Take Action with Problem Areas. Issues that arise as a result of this "self-audit" can be dealt with in the following ways.
- Incorrect reporting. Employers should determine whether amended corporate income tax returns or W-2 forms are necessary. If additional tax is due, the IRS will charge interest—and executives may incur additional expenses for the preparation of an amended return. It is always better to correct a problem before the IRS determines that it needs correction.
- Improper documentation. On an ongoing basis, employers should ensure that documents related to the program reflect what is indeed occurring. If what is intended to happen is not truly happening, operations should change on a prospective basis.
- Missing documentation. Employers should create appropriate documentation that reflects what has been done in the past and can be used as a guide for future reporting and administration.
Conclusion
Not all companies will be selected for audit. Yet, the fact that the IRS is examining this highly sensitive area should give employers the impetus to review their current programs. This way, employers will protect themselves with regard to compliance with current tax laws, and will improve the company's consistency, cost savings, competitiveness, and relationship with its goals. If a company has grown by acquisition or merger, it should consider whether its legacy plans meet its current goals.
Finally, executive compensation programs that are properly documented and clearly communicated can eliminate misunderstandings between executives and their companies. Such a resolution is greatly preferred to the alternatives, in which such misunderstandings may be distracting and adversarial.
References
Ted Ginsburg, JD, is a consulting principal with Top Five Data Services Inc. (Fremont, CA).
Illustration by JONATHAN EVANS/ARTVILLE
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