The IRS Eyes Executive Compensation: Will You Be Ready When The Tax Man Calls?
The plethora of stories in recent years about executive compensation excesses has prompted action on a number of fronts. Investors have weighed in with a flurry of shareholder initiatives during proxy season. Financial advisors such as Institutional Shareholder Services have made negative recommendations to their clients concerning many equity-based plan proposals.
The plethora of stories in recent years about executive compensation excesses has prompted action on a number of fronts. Investors have weighed in with a flurry of shareholder initiatives during proxy season. Financial advisors such as Institutional Shareholder Services have made negative recommendations to their clients concerning many equity-based plan proposals. The New York Stock Exchange and NASDAQ instituted new corporate governance initiatives and requirements for shareholder approval of equity-based plans. Congress enacted the Sarbanes-Oxley Act of 2002 and has been considering numerous other pieces of proposed legislation affecting executive compensation.
Not to be outdone, last year the Internal Revenue Service (IRS) launched a pilot program to gather data on executive compensation practices and compliance at two dozen large public companies with the goal of establishing a database to be used in more wide-ranging examinations. More specifically, the IRS has identified the following eight subjects as particular areas of interest in its program: nonqualified deferred compensation, stock-based compensation, the million-dollar cap on deductible compensation under Section 162(m) of the Internal Revenue Code (Code), golden parachutes, split-dollar life insurance, option transfers to family limited partnerships, offshore employee leasing, and fringe benefits. Businesses should expect that future examinations by the IRS will include a focus on those subjects.
Nonqualified Deferred Compensation
The nonqualified deferred compensation plans that are an integral part of many companies’ executive compensation programs create a number of issues of interest to the IRS. The ability to defer tax liability is appealing to executives, although the associated loss of control over the money is not. Attempts to postpone deferral and payout elections to the last possible moment while retaining access to the funds (e.g., through emergency withdrawal provisions that, in practice, do not require that an emergency exist) raise constructive receipt issues that could result in accelerated recognition of tax. In some circumstances the investment returns credited to the accounts of participants may themselves constitute additional contributions with additional tax consequences. Even if the plan successfully delays the income tax liability for the deferred compensation, the employment tax rules require the withholding and payment of employment taxes on a different schedule–when the services have been performed or there is no longer a substantial risk of forfeiture, whichever occurs last, rather than when payment is actually received by the executive. As a result, the IRS will look to see whether the required employment taxes have been paid at the proper time. From the employer’s perspective, the deferral of income by the executive results in an unwanted delay in the associated tax deduction even if the employer has contributed funds to a “rabbi trust” for the executive’s benefit. The IRS will be looking to see whether the employer has postponed its compensation deduction until the year in which the associated payment is includible in the executive’s income. Rabbi trusts (especially those maintained offshore) and other devices to secure the accounts of participants will also receive scrutiny.
The many different forms of stock-based compensation (e.g., restricted stock, incentive stock options (ISOs), nonqualified stock options, stock appreciation rights, phantom stock and employee stock purchase plans), and the increasingly heavy reliance in recent years on stock-based compensation as a major component of executive pay, generate a large number of issues of concern to the IRS. Among these are whether income is reported and withholding taxes collected and paid at the proper time (such as when restricted stock ceases to be subject to a substantial risk of forfeiture or when a nonqualified stock option is exercised); whether the requirements for electing the accelerated recognition of income are met (the so-called 83(b) election); whether the formalities required for ISO treatment are properly observed (such as timely shareholder approval of the plan, exercise price not less than fair market value at date of grant, and compliance with the applicable employment requirements); and whether the required participation standards are met for employee stock purchase plans.
Section 162(m) Million-Dollar Cap
Code Section 162(m) generally limits to $1,000,000 the tax deduction for annual compensation paid to an executive officer of a publicly traded corporation. However, certain types of payments (generally described as performance-based) are excluded from the 162(m) limit and therefore remain deductible even if they cause annual compensation to exceed $1,000,000. The IRS will be looking to see whether the deduction limitation has been properly applied or whether compensation deductions have been taken in excess of the amount permitted by Section 162(m). In addition, because the 162(m) restriction only applies to payments to persons who fill specified corporate offices as of the last day of the year, the IRS will be checking to see whether the restriction has been circumvented by end-of-the-year gamesmanship–i.e., resignation from office prior to year-end followed by a reinstatement to a covered office at the beginning of the next year.
Congress adopted Code Section 280G twenty years ago to combat what it considered to be excessive payments made to corporate executives in connection with transactions involving a change in ownership or control of a public company or some non-public companies. Although not all payments are taken into account and the related calculations get rather complex, once the value of the relevant cash and noncash payments (parachute payments) reach a certain level, Section 280G generally denies the company a compensation deduction for any amount above the executive’s average annual pay for the preceding five years (called an excess parachute payment). At the same time, Code Section 4999 penalizes the executive by imposing a 20 percent non-deductible excise tax (in addition to the normal income tax) on the amount received in excess of that average annual pay. Subjects of interest to the IRS include whether all required payments have been taken into account; whether the amounts of the average annual pay, the parachute payments and any excess parachute payments have been correctly calculated; and whether all applicable income and excise taxes have been withheld and reported.
Split-Dollar Life Insurance
Split-dollar life insurance has been the subject of a number of developments in recent years, including concerns under Sarbanes-Oxley (is there an extension of credit?) and less favorable tax treatment under new IRS regulations. The tax treatment of individual split-dollar arrangements is subject to a number of variables, including whether the arrangement is eligible for protection under certain grandfather rules, whether material modifications have been made to the arrangement, and whether the applicable premium rates are generally available to the public. In connection with its executive compensation initiative, the IRS has announced that it will be looking to see whether appropriate amounts have been included in the income of the employees covered by split-dollar arrangements (e.g., the value of term protection at a minimum or the value of the policy if it has been transferred to the employee). The appropriate amount of includible income will be a function of how a number of variables affect the split-dollar program. For additional information on split-dollar life insurance, visit www.sgrlaw.com/publications and click on Trust The Leaders, Summer 2003 Issue.
Transfers of Stock Options to Related Parties
Code Section 83 applies to compensatory transfers of property (such as corporate stock) and compensatory grants of nonqualified stock options. Although compensation income is generally recognized under Section 83 when restrictions on stock lapse (i.e., when the stock vests) or the stock option is exercised, the regulations issued under Section 83 provide for different treatment when the property is transferred by the employee prior to vesting or exercise. In that case, if the transfer is at arm’s length, the amount received on the transfer is treated as compensation to the transferring employee, and the transferee recognizes no income in the future when the stock restrictions lapse or the option is exercised. To take advantage of that treatment in a way not intended by Congress or the IRS, some aggressive taxpayers (frequently at the urging of even more aggressive tax shelter promoters) have structured transactions in which compensatory options have been transferred to a family limited partnership (FLP) or some other related entity in exchange for a promissory note with a principal amount equal to the fair value of the option (so that the transfer appears to be arm’s length) but with principal payments deferred for many years. When the option is later exercised, neither the employee nor the FLP reports any taxable income, and the employee reports compensation income only in the future when payments are received on the note. To better scrutinize these transactions, the IRS has categorized them as “listed transactions” that are subject to the list-keeping, registration and disclosure requirements that were put in place to combat abusive tax shelters. In addition, the IRS revised the regulations under Section 83 to provide that the transfer of an option by the employee to a related party does not close the compensation element of the option even if the transfer is at arm’s length. As a result, the IRS will be looking to see whether employees’ option transfers and subsequent exercises have been accompanied by appropriate tax recognition, withholding and reporting.
Offshore Leasing of Employees
The offshore leasing arrangement of concern to the IRS is a device that has been used inappropriately (in the view of the IRS) to reduce corporate income taxes and employment taxes. In the typical arrangement, an executive will resign from employment with a domestic corporation (the “original employer,” generally but not always controlled by the executive) and enter into a new employment relationship with a foreign entity organized in a jurisdiction having a tax treaty with the U.S. The foreign entity leases the services of the executive to a domestic U.S. entity that, in turn, leases the executive’s services to the original employer. The executive continues to sit at the same desk and to perform the same services for the original employer, but the original employer and the intermediary leasing company treat the payments they make as business expenses (other than compensation) that are not subject to employment taxes or to timing constraints on deductibility. The foreign leasing company claims the benefit of the U.S. tax treaty and, because it has no permanent establishment in the U.S., treats its revenues as exempt from U.S. income tax. The excess of those revenues over the amount paid to the executive (the equivalent of deferred compensation) is held for the executive’s benefit in an arrangement that in form avoids constructive receipt but in substance allows the funds to be protected from creditors and to be controlled by the executive.
As in the case of option transfers by employees to related parties, the IRS has classified these arrangements as listed transactions subject to list-keeping, registration and disclosure requirements. The IRS has announced its intention to challenge these arrangements on a number of grounds and assert that additional income taxes and employment taxes are payable. In connection with its executive compensation initiative, the IRS will be looking to see if any such offshore employee leasing arrangement is in place, whether applicable income taxes and employment taxes have been reported and paid, and whether deductions have been claimed earlier than allowed.
Fringe benefits come in many shapes and sizes and include such diverse elements as health insurance, executive physicals, employee discounts, club memberships, car allowances and personal use of business aircraft. The value of those benefits generally constitutes additional taxable compensation for the recipient unless some specific exclusion applies to make the benefit nontaxable, and eligibility for such an exclusion often requires strict compliance with eligibility criteria (such as nondiscriminatory availability). The IRS will be looking to make sure businesses have been properly treating fringe benefits as taxable unless the applicable requirements for exclusion from income have been met. Benefit types in which the IRS has announced a particular interest include relocation benefits and personal use of corporate-owned aircraft and automobiles.
Now Would Be a Good Time for a Preventative Compliance Audit
Forewarned is forearmed. A stitch in time saves nine. An ounce of prevention is worth a pound of cure. These maxims have stood the test of time for a good reason–they’re good advice. With advance notice of the topics that are of special interest to the IRS, businesses have the opportunity to avoid headaches in the future by reviewing their executive compensation programs and procedures now. Plans may not have kept up with changing legal requirements. The replacement for the person who knew all about how things are supposed to work may not be familiar with all those picky technicalities. Or perhaps programs or benefits have evolved over time without ever being subjected to a legal or best-practices review. Whether conducted internally or with the assistance of an outside consultant or advisor, a compliance audit performed now can help you find and correct these and other problems before the tax man calls. And he will call.