IRS Eyeing Executive Pay

The Securities and Exchange Commission isn't the only regulator taking a closer look at executive compensation. The Internal Revenue Service will be scrutinizing executive pay this tax season too, as part of its continuing effort to force more companies to treat fringe benefits as wages for income and employment tax purposes.

In 2004, the IRS launched a pilot program to investigate 24 companies already under audit to gauge their level of compliance with executive compensation rules. The test group fared poorly, and, as a result, executive pay became "an area for agents to focus on," says an IRS spokesperson. Since then, the agency has released tax guidance in the form of a 2005 memo called an "audit technique guide," and continues to keep a watchful eye on how companies book executive bonuses and perks. This year is no exception.

The IRS won't only be looking at high-profile items, such as stock option expensing and no-cost loans this year. Agents will be looking into more mundane areas, such as life insurance for spouses, club memberships, and transfer of company property, says Douglas Rogers, an executive with specialty insurance broker and consultancy Risk Capital Partners. He should know. Until he left the IRS in January, Rogers was the director for Penalties and Interest, the department that assures fines are assessed, and interest calculated, consistently.

Rogers explains that the IRS doesn't care about "how much" a company pays its executives. Rather the emphasis is on what form the pay takes, and how the payment is characterized in terms of an expense deduction, as well as its effect on withholding and other payroll taxes.

Based on his 32 years of experience with the agency, Rogers worked up a list of compensation perks that may not seem unusual or controversial, yet may pique the interest of agents focused on uncovering compensation violations. Here are Rogers picks:

Partnership payments. In some cases, executives form a partnership — either domestic or foreign — into which bonuses are paid. One advantage for the employer in such arrangements is that the company avoids paying certain payroll taxes, including unemployment and FICA taxes, because a third-party (the partnership) is involved. Generally, such a move is motivated by the tax savings, and therefore should be thoroughly vetted by tax experts. Although the set-up can be legal, and the IRS reviews each on a case-by-case basis, Rogers warns that the partnerships are likely to attract the agency's attention.

Club memberships. If you're not Tiger Woods, then membership dues to the Augusta National Golf Club are probably not a deductible expense. In 1994, the U.S. Tax Code was updated to clarify whether membership dues to sporting and entertainment clubs can be recorded as a deductible expense. If the club is not directly related to an executive's business, chances are the company will not get a tax break, and the value of the membership needs to be factored into the executive's annual gross income as compensation.

Corporate credit cards. Giving the boss a rubber stamp for credit card expenses can cost the company. In general, companies that issue credit cards have reimbursement plans in effect that limit usage by requiring employees to file expense reports and hand in receipts that substantiate the business expense. In these cases, the refund is not a taxable payout to the employee and is not included in gross income statements.

But in many companies, executives submit their credit card bills directly to the accounts payable department without accounting for expenses, and often without usage restrictions. Because the bill is being submitted by a top executive, the credit card invoice often is paid automatically — no questions asked. But without documenting the charges properly, reimbursements may not pass muster as a business expense in the eyes of the IRS. Rogers suggests making sure that the company follows the basic reimbursement requirements laid out in IRS Regulation 1.62-2(c). If a company runs afoul of the regulation, both the employment tax return for the company, and the employee's Form W-2 will be incorrect.

Outplacement services. Being gracious about layoffs is not a tax deduction, unless everyone receives the benefit. Outplacement services — such as providing offices, phones, Internet access, resume-writing services, and employment counseling sessions for departing executives — is a nice gesture. But it's also a perk. A company cannot deduct the incurred expenses unless some type of outplacement services are offered to all classes of employees. Uncle Sam allows companies to develop different levels of services for different employment classes, but the fringe benefit has to apply to the corporate masses before it's considered a deductible expense.

Spousal and dependent life insurance. Companies often offer to pay group-term life insurance premiums for top executives and their families. But the portion of the premium assigned to wives, husbands, and children usually should be recorded as part of the executive's gross income. In most cases, the premium cost is not taxable if the face amount of the coverage does not exceed $2,000 because the expense is considered a de minimis fringe benefit. IRS Notice 98-1110 provides more detailed information about this exception. But in general, the companies should follow the IRS "premium table," described in Section 79 of the tax code to determine the taxable expense.

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