IRS audit initiative targets executive compensation.

According to a November 2003 IRS Webcast, the Service has begun an initiative to assess compliance and target abuses related to executive compensation and benefits; it intends to implement more structured reviews of compensation arrangements during future examinations of large corporate tax returns.

In describing some of the reasons for the new program, Cate Livingston Fernandez, branch chief of the IRS's Executive Compensation Branch, indicated compliance with executive compensation laws has not been aggressively reviewed for years, and "people may have forgotten some of the fundamentals." Through the new effort, the IRS expects to identify areas in which taxpayers repeatedly make errors and may need additional guidance, added Keith Jones, a director of field specialists at the IRS's Large and Mid-Size Business Division.

Targeted Areas

At the program's inception, the IRS selected 24 sample companies from five industry groups from which to gather compliance information on executive compensation issues. Auditors examining the businesses will focus on eight primary areas: nonqualified deferred compensation, stock-based compensation, the $1 million cap on compensation paid to public company officers, golden parachute arrangements, split-dollar life insurance, fringe benefits and the use of two listed transactions (family limited partnerships and offshore employee leasing).

Fernandez explained that the IRS, in reviewing nonqualified deferred compensation arrangements, will examine timing of deductions for deferred amounts (i.e., whether the deduction has been postponed until the employee has corresponding income). The Service will also examine whether a company's deferred compensation arrangement triggers currently taxable income under either the constructive receipt or economic benefit doctrine, and whether the company has properly applied payroll taxes.

For stock options, the IRS may look at a number of issues, such as whether there has been proper income inclusion on option exercise (or on a disqualifying disposition of stock acquired from such exercise), participation rights in employee stock purchase plans and general statutory compliance. With issues such as the $1 million dollar cap under Sec. 162(m) and golden parachute payments, the Service will ensure proper compliance with statutory limits and regulations.

For split-dollar arrangements, the IRS will check whether a company has included amounts in income when an insurance product has been transferred from an employer to an employee. When fringe benefits have been provided to executives (such as the use of a corporate-owned aircraft or automobile, or relocation benefits), the IRS will verify that the company properly treated the benefit as wages for employment taxes.

Tax Shelters 

In line with the IRS's general crackdown on the use of tax shelters, it also plans to target the use of two types of listed transactions related to executive compensation. ("Listed transactions" are those die IRS has specifically identified in published guidance as "tax-avoidance" transactions, as well as those expected to produce the same or similar tax consequences.)

The IRS will scrutinize a taxpayer's attempt to defer income by transferring compensatory options to a related party in exchange for a deferred payment obligation. The IRS's view, as explained in Notice 2003-47, is that the transfer does not qualify as an arm's-length transaction; thus, compensation continues to accrue to the transferor and the deferral is ineffective.

The Service will also examine companies for tax schemes similar to those described in Notice 2003-22, which addresses individuals who use professional corporations or other taxable entities to attempt to avoid payroll and income taxes. Using this transaction, taxpayers take an accelerated current business expense deduction for deferred compensation through the use of an employee leasing arrangement in an offshore-tax-savings jurisdiction.

Examination Notification

At the initiative's onset, the IRS did not plan to specifically inform taxpayers that they were included in the executive compensation examination program, but information requests made during an audit will likely signal companies that they have been selected.

In a typical audit, the IRS examiners are expected to ask corporate tax departments to assist them in obtaining executives' Forms 1040, so that they can be reviewed for consistency with the corporate return. The executives' returns, however, will not be examined as part of the compliance effort. Rather, the examination's focus would be the timing of the employer's deductions and its compliance with reporting and withholding obligations. Executives of interest are corporate officers and perhaps 15 other highly paid individuals (possibly including former employees).

Looking Ahead

Beyond the pilot program's scope, the IRS plans to perfect executive compensation audit processes and expand resource allocations for these issues. Information gathered from the compliance program will be used to develop examination positions and procedures for use in future routine audits of large corporate returns. "We are clearly right in the middle of developing and implementing a comprehensive strategy around executive compensation areas," Jones said.

FROM BART MASSEY, CPA, J.D. LUTZ, CPA, MST, AND STEPHEN A. LAGARDE, WASHINGTON, DC