Executive compensation compliance initiative.
Besides reviewing returns, the Service will also match W-2 income to corporate returns. If it finds any discrepancies or other problems, it will expand the scope of the review beyond the 15-highest-paid employees.
Subsequent to a November 2003 IRS Webcast about the audit program, additional details have emerged. During a January 2004 panel discussion with the American Bar Association, Alan Tawshunsky, IRS Assistant Chief Counsel, laid out a more institutionalized compliance and examination program. According to Mr. Tawshunsky, the initiative for uncovering noncompliance is a basis for focusing future examination resources on more technical issues. For perspective, Mr. Tawshunsky said that the idea was not just to look at 24 test companies, but to build a knowledge base. Further, the IRS also wants to develop an infrastructure for conducting these types of examinations on a wider basis. It can be expected that the initiative will be a highly publicized and coordinated effort.
This executive compensation compliance initiative will focus on eight issues: (1) nonqualified deferred compensation; (2) stock-based compensation; (3) the $1 million cap on deductible compensation; (4) golden parachutes; (5) split-dollar life insurance; (6) transfers of compensatory options to related parties; (7) offshore deferred compensation arrangements; and (8) executive perks.
The tax law has not changed; the Service is just refocusing on executive compensation, which, in recent years, has become more complicated to administer. Tax directors, chief financial officers and human resources officers should pay close attention to the areas the IRS has outlined. They can still address 2003 compliance issues and, in some instances, noncompliance from previous years.
Nonqualified Deferred Compensation
The IRS will focus on the tinting of employer deductions and executive income recognition for deferred compensation. In particular, it is concerned about proper application of the constructive-receipt and economic-benefit doctrines, especially for certain vehicles used to "fund" these nonqualified arrangements (e.g., offshore trusts and rabbi trusts). If a deferred compensation agreement is poorly drafted, an executive may be subject to current taxation under either of these doctrines on amounts deferred, even though he or she may not have received cash.
Deduction timing: The Service will also confirm compliance with the Sec. 404(a)(5) rules on deduction timing, and whether an employer is properly delaying deductions until the employee recognizes income. It will also examine proper withholding of employment taxes. Amounts deferred under a nonqualified deferred compensation plan are subject to FICA when the services are performed or when the deferred amount is no longer subject to a "substantial risk of forfeiture." Typically, amounts deferred under an unfunded nonqualified arrangement will not be forfeitable. Thus, such amounts are FICA compensation in the year the executive performs the services, not when he or she receives the amount, resulting in FICA withholding.
Deferred compensation: The IRS is also concerned about executives' ability to control the timing of deferred compensation. In some instances, a deferred compensation plan may be well written, but the participants are in a position of influence and authority over a plan administrator. The Service is aware that it takes courage to say "no" to an officer-plan participant who is demanding improper distributions. When executives can voluntarily defer compensation during the plan year, the Service will examine whether such executives could determine the actual amount deferred and make the deferral, and whether they are in violation of the constructive receipt doctrine.
Other issues: The IRS also plans to scrutinize two other areas. The first is the funding of deferred compensation with offshore rabbi trusts. Although these trusts are subject to creditors' claims, creditors have difficulty locating and accessing the funds. If these trusts were partially funded and, subsequently, early distributions occurred near or at bankruptcy, the Service would probably inquire further.
The second area is an executive's ability, to access previously deferred compensation by electing to receive a distribution subject to a penalty (e.g., a 10% haircut). The IRS will scrutinize the procedures needed to access the previous deferral, the timing of early distributions and the extent to which deferral was real, not just a temporary delay in receipt.
In recent years, stock-based compensation has been alleged to be the most abused by company executives and highly compensated employees (HCEs). This involves use of restricted stock; options (i.e., incentive stock options, options granted under employee stock purchase plans (ESPPs) and nonstatutory stock options); stock appreciation rights; and phantom stock. The IRS will scrutinize such compensation to ensure proper income recognition on vesting and on disqualifying dispositions.
Although legislation has not been passed nor stock-based compensation highly regulated historically, the public's perception of corporate greed and abuse has pressured the Service into ensuring corporate compliance. For all stock option plans, it will examine whether shareholder approval was received and, for ESPPs in particular, whether (1) ,all employees were able to participate, (2) procedures were properly followed and (3) statutory limits were not exceeded.
$1 Million Cap on Deductible Compensation
For tax years beginning after 1993, Sec. 162(m)(1) limits the tax deduction for compensation paid to the top five HCEs (as listed in the proxy of public companies) to $1 million each. Exceptions to this cap include payments to qualified retirement plans and for performance-based compensation used by public companies to pay compensation in excess of the $1 million limit. The IRS believes that companies are deducting more than $1 million without valid exceptions.
Companies must be able to prove that criteria for performance-based compensation have been met, including (1) pre-established goals, (2) compensation truly contingent on attainment of such goals, (3) timely shareholder approval and (4) proper certification of goal achievement. The IRS is concerned that companies are not treating pay and pay for performance as if they are related and wants to erasure that if compensation is supposed to be exempt from the limit, it is actually performance-based in practice.
Golden parachute payments made to corporate executives, which are contingent on a change in ownership or control, are limited under Sec. 280G. Generally, when the payments' present value exceeds three times the base amount (the annualized W-2 compensation over the last five years), the corporation cannot deduct the portion of the compensation payment exceeding the safe-harbor amount. Under Sec. 4999, the recipient is subject to a 20% nondeductible excise tax. As golden parachute payments are usually quite large, the IRS will closely examine them and the calculations supporting compliance. It issued final regulations (TD 9083, 8/1/03) mentioning specific interest in (1) valuing stock options under Rev. Proc. 2003-68, (2) Rev. Proc. 2002-45 safe-harbor provisions and (3) computations of noncompete agreements.
After Square D Co., 121 TC (2003), the Service will scrutinize post-change-in-control employment agreements. In that case, the Tax Court concluded that when a tax payer forfeits a right under an agreement entered into before a change in control as consideration for rights under a new agreement, the payments under the later agreement will be deemed contingent on a change in control to the extent that those payments exceed the previously bargained--for amounts.
Split-Dollar Life Insurance
Beginning in 2001, in a series of notices and regulations, the IRS significantly changed its position on the taxation of split-dollar life insurance; see English, Tax Clinic, "IRS Again Revises Split-Dollar Insurance Rules, TTA, April 2002, p. 216, and Whitlock and Vogel, "Split-Dollar Life Insurance Alert!," TTA, August 2003, p. 479. As part of the audit initiative, it wants to establish whether executives have been including the correct amounts of income to comply with its new positions. Thus, it will look at whether the proper amounts have been included in income when a corporation transfers an insurance product to an executive, and whether the executive has at least included the value of the term protection in income. In addition, the relationship between the employee and the policyholder becomes even more complex after the Sarbanes-Oxley Act of 2002 (SOA).
Compensatory Options to Related Parties
According to the IRS, the greatest abuse of compensatory options is a technique involving transfers of such options to a related party (e.g., a Family limited partnership or a trust) in return for a deferred payment obligation. The executive regards the option as sold or otherwise disposed of in an arm's-length transaction for Regs. Sec. 1.83-7 purposes and recognizes no compensation income when the related person exercises the stock option, but does so only when that person pays the amounts due under the note. The Service took the position in Notice 2003-47, that this is not an arm's-length transfer but, rather, a tax shelter that does not effectively defer income recognition. Additional disclosures will be required, as these deals are now "listed transactions" Companies are on notice that the IRS perceives these transactions to be abusive and immediately reportable to tax authorities.
Offshore Deferred Compensation Arrangements/Asset Protection Plans
The audit initiative also covers offshore employee-leasing transactions that facilitate income and employment tax avoidance. These transactions generally involve an employee-leasing program with a nonqualified deferred compensation piece transferred to a tax-haven country. These techniques attempt to turn a delayed Sec. 404(a)(5) deduction into a current Sec. 162 deduction. They are marketed to wealthy individuals as asset protection plans. In Notice 2003-22, the Service took the position that these types of arrangements are impermissible tax shelters and do not avoid income recognition.
Executive Perks/Fringe Benefits
Corporate fringe benefits generally granted only to top executives (e.g., housing allowances, relocation expenses and use of corporate-owned aircraft and automobiles) are considered to be paid in lieu of, or in addition to, wages. These perks, unless specifically excluded under the Code, are taxable. According to the INS, there is considerable underreporting of income for such items, as well as noncompliance with the payroll withholding rules. According to Mr. Tawshunsky, the IRS is tired of top executives using the company as a "piggy bank." As part of the audit initiative, the Service will be verifying whether these benefits are being treated properly as wages for employment tax purposes.
What to Expect
To handle the additional work created by the executive compensation compliance initiative, the IRS has recently trained agents in the eight specific areas noted. The cost of corporate governance under the SOA is already burdensome; the initiative will add to the cost. In hoping to avoid IRS scrutiny and the resultant negative publicity (such as that received by Tyco, HealthSouth and WorldCom), tax directors should perform a compliance check-up to identify any executive compensation noncompliance issues. The IRS believes that there is potentially hundreds of millions of recoverable tax dollars. Mr. Tawshunsky indicated that it will use the information gathered through the initiative to construct a knowledge base and infrastructure to assist in future compliance. Thus, executive compensation reviews may become a regular part of all corporate audits.
FROM DERRICK P. NEUHAUSER, J.D., ATLANTA, GA
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|Author:||Neuhauser, Derrick P.|
|Publication:||The Tax Adviser|
|Date:||May 1, 2004|
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