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During the past few years the Internal Revenue Service (IRS) has devoted more resources, developed an examination program, and trained more of its agents to identify, review, and deal with executive compensation issues and their tax treatment on corporate income and payroll tax returns. Some of these initiatives are taking companies by surprise.

In the past, the IRS may not have asked to review or inspect an officer's or director's individual federal income tax return – be it for a privately owned or public company. It now is a standard request.

A list of some of the executive compensation areas that we understand the IRS has been questioning and some of its findings follow:

• Stock-Based Compensation
  ISOs – The IRS has found problems with incentive stock option (ISO) plans, especially with violations of the $100,000 cap under the Internal revenue Code (Code) and with shares sold during the employee's post-exercise holding period. As to the latter, generally, if the shares are sold within two years from the date of ISO grant or within one year from the date the shares are transferred, the sale creates a disqualifying disposition in which taxable gain or loss must be recognized that may not have been properly reported in taxable income.

  The Code states that no more than $100,000 worth of ISOs (determined using the original grant price) can become "first exercisable" in a given year, aggregating all ISOs issued to a given person. ISOs become first exercisable in the year in which the risk of forfeiture or vesting lapses. Shares that became first exercisable in a prior year, even if not yet exercised, are not counted toward this determination.

  The IRS has also found that some employers are not following the terms of their own stock compensation documents, thus creating a problem for ISO plans.

  Nonqualified Stock Options (NSOs) – The IRS has discovered that in various cases, the exercises of NSOs have not been properly reported. An NSO exercise is reported as compensation income on Form W-2 and is subject to FICA and federal income tax withholding if the individual earned the option by employment with the company; or on Form 1099-MISC (Box 7) if the individual earned the option for services performed as an independent contractor such as an independent director or outside consultant.

  The IRS has also indicated that there are significant failures in remitting the payroll tax under the "next-day deposit rules" on many types of equity compensation, resulting in "millions of dollars in penalties."

  We also understand the IRS has discovered that some employers have not been including compensation at the right time, i.e., in the correct taxable year for employees, such as upon vesting for restricted stock plans pursuant to the rules of Section 83 of the Code.

  Employee Stock Purchase Plans (ESPPs) The IRS has found that some ESPPs are not properly covering all required employees. An ESPP must generally offer the same benefit to all employees of the company with a few exceptions such as part-time employees, employees without sufficient longevity of employment, temporary employees, etc. Failure to satisfy this requirement could invalidate the special ESPP tax treatment.
  
  

  

  An ESPP permits an employer to offer employees an option to purchase employer corporation stock with a discounted option price of not less than the lesser of either (i) 85% of the fair market value of the stock on date of grant or (ii) an amount which under the terms of the option may not be less than 85% of the fair market value of the stock at the time the option is exercised. Just like ISOs, the profit on the date of exercise is not treated as compensation, but if the employee sells the shares before the end of the holding period (two years from date of option grant or one year from date of exercise), the employee has taxable compensation income, and the employer a tax deduction. Based upon the Code and the Treasury Regulations (Reg.), there are additional situations such as in a qualifying disposition or upon the individual's death where the discount would result in compensation to the employee, but no tax deduction for the employer.
  
  

• Nonqualified Deferred Compensation
  A surprising finding has been that a number of companies, including some large corporations, are taking deductions for contributions to nonqualified deferred compensation plans at the time of the deferral.

  In addition, the IRS has stated that FICA reporting on nonqualified plans has been an issue in some examinations. Please note that if a company discovers that it has failed to report amounts credited to "account-type" nonqualified deferred compensation plans as FICA wages as the amounts were credited (or when no longer subject to a substantial risk of forfeiture, if later), the company may be able to correct the failure to pay the FICA tax and withholding.

  Secular Trusts – The IRS has found in various nonqualified deferred compensation plans that are "secular trusts" that the contributions have not been properly accounted in the employee's taxable income as required under the Code. A secular trust is a nonqualified deferred compensation arrangement that has been set aside for employees in a separate trust, rather than, e.g., a "rabbi" or grantor trust that still belongs to the employer. As an asset of the employer, if the assets in a rabbi trust are subject to claims of company creditors, the employee "beneficiary" avoids constructive receipt of the funds. On the other hand, an employer may create a secular trust specifically to protect assets from the reach of company creditors. In such a case, the employee is deemed to have constructive receipt of the funds – and thus taxable income - at the time of funding.

  However, sometimes an employer inadvertently makes the assets in a rabbi trust too secure, thus unintentionally creating a secular trust. Amounts in a secular trust are includable in employee income once they are no longer subject to a substantial risk of forfeiture. In addition, earnings on vested amounts may also be included in employee income.

  Further, the IRS found a number of nonqualified deferred compensation plans in which the accounts had been "made available" to the individuals. This gave the employees constructive receipt of the funds, thus the amounts should have been included in the employees' taxable income in the taxable year when made available.
  
  

• Cap On Deductions For Compensation In Excess Of $1 Million
  The IRS indicates that it has found various compliance issues with respect to Section 162(m) of the Code which deals with limits on deduction of compensation for certain officers of publicly traded corporations. Some of those were lack of shareholder approval, proper proxy disclosure issues, lack of approving minutes, lack of outside directors on compensation committees, and situations where goals were not met, but compensation was still paid and fully deducted. In addition, the IRS has found that some companies have changed performance goals during the year, while in other companies, compensation committees appeared to "rubber stamp" performance compensation approvals.
  
  
• Taxable Fringe Benefits
  The IRS has listed various areas in which agents have discovered problems with taxable fringe benefits. Below is a list of some of them:
  • Aircraft use – The IRS has found that some companies use an honor system under which executives and officers are supposed to self-report personal time on the employer's aircraft. The IRS suggests that this method is not working.
  • Dependent and spousal travel – The IRS has indicated that companies mistakenly believe that if they require executives' spouses to attend business meetings, the cost is not compensation to the executives. Spousal and dependent travel is almost always includible in the employee's income.
  • Club dues – The IRS has found that Companies are not including such payments as compensation to the employee while on the other hand, they allow themselves of a tax deduction. Companies can deduct the expense of club memberships only if that expense is included in the employee's income.
  • Personal use of corporate credit cards – The IRS has discovered the same problems just like Club dues and it further states that companies need a mechanism for segregating business expenses from personal expenses.
  • Employer-paid vacations – The IRS has found that the value of employer paid vacations, which is generally compensation for the employee, has not been accounted for as such.
  • Loans – The IRS has stated that loans to employees are a big problem, however, it is slowing "going away" as the Sarbanes-Oxley Act eventually applies to more taxpayers in years to come.
  • Transportation of executives – The IRS has found that personal transportation of executives - whether chauffeured or in an employer provided vehicle – have not been accounted as taxable compensation to the employee. It also stated that companies should be able to "log" such transportation and include it in the recipient's compensation.
  • Tax preparation and financial planning – Again the IRS has found that these services have not been included in the employee's compensation while they almost always should be.
  In addition, the IRS has also found that in some cases companies are failing to report consulting fees paid to former executives and forgiveness of loans.
  
  
• Transfers Of Compensatory Options
  The IRS has found a "surprising number" of transactions in which compensatory options are transferred to family limited partnerships in an "arm's length transaction." Such a transfer is a listed transaction (Notice 2003-47, IRB 2003-30, 132) and the IRS is reviewing the disclosures sent in on this issue.
  
  
• Parachute Payments and Change Of Control Issues
  There are many issues in this area along with some that have never been seen before. Hence, the IRS is now looking more closely at change in control issues such as shareholder approvals (non-public companies) and covenant-not-to-compete issues.

  Further, the IRS has seen a number of instances in which employees gave up parachute payments for larger payments from the new employer. In such a situation, one Tax Court decision, Square D Company and Subsidiaries v. Commissioner, 121 T.C. 168 (2003), found that lump sum payments made to the taxpayer's (a U.S. electrical corporation) top executives, defined as "disqualified individuals" under the Code, under a post-acquisition agreement with a new foreign parent corporation, were contingent on the taxpayer's change in ownership or control under Section 280G of the Code.

  Thus, following the legislative history's clear dictate, the term "contingent on change in ownership or control" required only that there be causal nexus between ownership/control change and the payment. That nexus was clearly established in the case by the facts that the executives used parachute payment rights that they held under a pre-change agreement to negotiate a post-change agreement and the subject parachute payments. Also, the taxpayer's reliance on a proposed Reg. was misplaced since the post-change agreement was, by its terms, dictated by and entered into "pursuant to" the pre-change agreement.

  The IRS is now arguing that most of these larger payments from new employers could be parachute payments.
  
  

• Split-Dollar Life Insurance
  The IRS has found that companies have not been reporting the proper amounts in taxable income, however it is waiting for results from more recent examinations since the newer regulations were not in effect during earlier examinations.

Over the past year, we have seen an increase in corporate audits by the IRS in which many of the executive compensation issues discussed above have been questioned or examined in detail by IRS agents. It is now obvious that the "kinder, gentler IRS" of the 1990s, is taking a more rigid enforcement oriented approach and the IRS agents appear to be better trained and equipped as to these executive compensation issues.

The best defense against these issues would be for any company to consider reviewing its executive compensation arrangements, evaluate its reporting procedures, and make any necessary changes or corrections before an examination commences.

On a prospective basis, each company must now consider the impact of Section 409A of the Code on any deferred compensation arrangements – both those existing and any new ones. The details of this relatively new Section of the Code are beyond the scope of this article and the Code Section was not even in effect as to the items reported in these examinations. Its effects, however, are far-reaching and it needs to be closely reviewed to avoid unintended results. The Service will certainly incorporate the provisions of Section 409A in its future reviews of deferred compensation arrangements.