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IRS treatment of executive compensation.

Staying on top of ever-changing tax rules.

In recent years, Congress has significantly changed the tax treatment of many common forms of compensation provided by associations to their executives. Because substantial liabilities can result from failing to comply with tax rules, you need to stay current with those pertaining to your association's plan.

Following and understanding the rules can be difficult. To assist you, here's a review of the income and employment tax treatment of the most common forms of compensation.

It is helpful to think of compensation in several different forms:

* cash and equivalents, which are taxable currently;

* pension and welfare or insurance benefits, which are usually tax-deferred or tax-free, if (in most cases) certain nondiscrimination or other rules are satisfied;

* employment-related fringe benefits, which are usually tax-free; and

* other tax-free statutory fringe benefits.

Other benefits provided to association executives usually are taxable currently.

Nondiscrimination rules. For many pension, welfare, and other fringe benefits to be tax-free or tax-deferred, the benefit must be provided or available to both highly compensated and lower-paid employees on a nondiscriminatory basis. Although the Tax Reform Act of 1986 rationalized many of these rules, particularly for qualified pension plans and tax-sheltered annuities, you need to examine carefully the nondiscrimination rules applicable to each benefit. Your association must comply with these rules when adopting and administering benefit plans.

Welfare and insurance benefits. The most common benefits and current tax treatment for each are as follows:

* Medical insurance. Associations may provide tax-free medical insurance to all employees without regard to nondiscrimination rules. However, if medical benefits are provided through a self-insured medical reimbursement plan (other than payment for routine medical examinations), these benefits must be available on a nondiscriminatory basis. Otherwise, the benefits received (or that could have been received) by the association's highly compensated employees are taxable.

* Disability insurance. Disability insurance premiums paid by the employer are normally not taxable, but the benefits are subject to tax. Alternately, if the employee pays for the insurance with after-tax dollars, the disability benefits are not taxable.

* Split-dollar insurance. Under current Internal Revenue Service rulings, the value of the interest-free "loan" used to purchase a "split-dollar" insurance policy, frequently provided to a chief executive officer, is not taxable to the extent it exceeds the premium cost for current insurance protection. However, the below-market loan rules in Section 7872 of the Internal Revenue Code suggest that IRS could impose tax on that value if it revoked the current rulings. If IRS were to change its position, the change would not likely affect existing arrangements.

* Group-term life insurance. The premium paid by the association for the first $50,000 (face value) of group-term life insurance is not taxable if the plan is nondiscriminatory.

* Other forms of life insurance. Premiums paid for other forms of life insurance, such as whole life, universal life, or individual term policies, are subject to tax if the executive or his or her family is the owner or beneficiary of the policies.

* Dependent care. Employer payments for dependent care--for example, child care--are tax-free to the extent they do not exceed $5,000 ($2,500 for a married employee filing a separate return) and are provided under a nondiscriminatory plan. The untaxed amount reduces the child care credit that is otherwise available.

Cafeteria plans. With increasing frequency, welfare benefits are being provided under the aegis of "cafeteria plans," described in Section 125 of the Internal Revenue Code. These plans let employees choose between receiving an amount in cash or using all or a portion of that amount for various employer-provided, tax-free benefits. Although most noncash benefits provided through cafeteria plans are tax-free, cafeteria plans are subject to additional nondiscrimination rules. Also, these plans cannot provide pension or deferred compensation in any form (other than through a Section 401(k) plan). For example, funds provided for one plan year cannot be used to provide benefit coverage in a subsequent plan year.

Pensions and deferred compensation. Employer contributions for pension benefits are not currently taxable if the benefits are provided under a "qualified" pension or profit-sharing plan described in Section 401(a) of the code. (This includes a Section 401(k) plan adopted by an association before July 2, 1986.) Instead, the benefits are taxed when they are distributed from the plan to the employee.

Three other types of deferred compensation plans are

* Nonqualified deferred compensation plans. Association executives may participate in certain "eligible nonqualified deferred compensation plans," described in Section 457(b). Amounts deferred under such a plan are also tax-deferred, provided (among other rules) they do not exceed $7,500 per year. Additional amounts may be deferred under a separate Section 457(f) plan, provided they are subject to a "substantial risk of forfeiture." Amounts deferred under a Section 457(f) plan are subject to tax when the risk of forfeiture lapses, regardless of when the amounts are actually paid to the executive.

* Tax-sheltered annuity plans. Executives who work for Section 501(c)(3) or educational organizations may also participate in tax-sheltered annuity plans, described in Section 403(b). Under these tax-sheltered plans, an employee may defer up to $9,500 per year, to be invested in an annuity contract or mutual fund custodial account. Additional, nonelective contributions may be made by the employer. Amounts deferred under a nondiscriminatory plan are not subject to tax until distributed to the employee.

* SEP-IRAs. The simplest form of tax-deferred pension benefit is a simplified employee pension, funded using each participating employee's individual retirement account. The association establishes a SEP-IRA plan using IRS Form 5305-SEP and contributes the same percentage of compensation for each eligible employee. All amounts are paid directly to the employee's IRA and are treated like any other funds invested in an IRA. The $2,000 the employee may contribute to the plan is not reduced by the association's contribution.

Special rules. The rules governing the tax-deferred nature of pension plans are extremely complex and frequently revised by Congress and IRS. The rules often offset benefits provided under one type of plan against the maximum benefits that may be provided under another type of plan. Thus, unless consulting with tax counsel familiar with pension plans, associations should provide only the simplest forms of pension benefits.

ERISA. Employee welfare and pension benefits are also subject to the Employee Retirement Income Security Act of 1974. (ERISA's nontax rules are administered by the Pension and Welfare Benefits Administration of the Department of Labor.)

Employment-related benefits. Many associations provide their executives with use of a car, payment of club or association dues, expense accounts, and travel for the executive's spouse to association board or membership meetings. To the extent the cost of these benefits would be deductible by the executive, the amount paid by the association for these benefits is not taxable to the executive. The benefits are deductible if they are "ordinary and necessary," noncapital expenses incurred in the course of the person's trade or business of being an association executive. Following are some specific examples:

* Club dues. An association's payment of a one-time club initiation fee is taxable because the fee is a capital expense. However, payment of club dues is not taxable if at least 50 percent of the use of the club by the executive and his or her family is for business purposes. In addition, the payment of charges for such items as particular meals and greens fees is also not taxable, subject to the substantiation rules in Section 274 of the Internal Revenue Code. The pending tax proposal is likely to require associations to include payments of club dues in income, although payments for particular business charges would continue to be tax-free.

* Spouse's travel costs. The association's payment of the cost of a spouse's travel to association meetings is not taxable if the spouse is present for a noncompensatory, employment-related reason. Like the pending changes in the treatment of club dues, the Clinton administration's tax proposal will probably require associations to include the cost of spouse travel in income unless the spouse is also a bona fide employee of the association.

* Automobile use. An association's provision of an automobile for unrestricted use by its executive is normally taxable income. Use of the car is tax-free to the extent the chief executive officer substantiates each business use (exclusive of commuting) of the car with records showing the date, place, business purpose, and mileage.

* Reimbursement of other expenses. An association's reimbursement of other business expenses incurred by the chief executive officer is also taxable income, except to the extent that the expenses are reimbursed pursuant to an "accountable business expense reimbursement plan." Such a plan must require substantiation of the date, place, amount, and business purpose of the expense. With meals and other business entertainment, these rules require a direct link between the conduct of substantial business activities and the meal or form of entertainment.

Parking. Although employer-provided parking, either on the premises or nearby, formerly was tax-free, the cost of parking is now taxable to the extent it exceeds $155 per month.

Other benefits. Employees may also receive other benefits on a tax-free basis if various special rules are satisfied. Such benefits include "qualified employee discounts" on products the association sells, "de minimis fringe benefits" that the association offers only occasionally or that are difficult to account for, and use of on-premises cafeterias and athletic facilities.

Employment tax withholding and reporting. In general, when an association provides a taxable benefit to an employee, the association must periodically withhold income and, if appropriate, Social Security taxes on the cost or value of the benefit. In addition, the association must report the income and tax amounts on the Employer's Quarterly Tax Return, Form 941, and Form W-2. Reporting on Form 1099 is required when an association provides taxable benefits to an independent contractor and two conditions are satisfied: 1) the contractor is operating as a sole proprietor or partnership and 2) the total reportable compensation paid to the contractor is at least $600 in any calendar year. (The $600 includes benefits that would be tax-free when provided to employees.)

The rules governing taxation of noncash compensation are complex and subject to frequent change. Tax treatment of benefits provided to an association executive may depend on the application of several rules, some requiring the association to satisfy nondiscrimination standards that may differ with respect to each benefit.

The failure of an association or executive to understand and comply with tax rules may trigger substantial liabilities for employment tax withholding and income tax. These liabilities include penalties and interest with respect to past years--for both the association and the executive.

By keeping regular counsel about tax rules, your association can provide benefits to its executives without undue concern about the Internal Revenue Service.

George D. Webster is general counsel to ASAE and a partner in Webster, Chamberlain & Bean, a Washington, D.C., law firm.
COPYRIGHT 1993 American Society of Association Executives
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Title Annotation:taxation laws on association executives' compensation
Author:Webster, George D.
Publication:Association Management
Date:May 1, 1993
Words:1813
Previous Article:Let's get away from it all.
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