July 31, 2017
Executive perks that are not properly reported to the IRS can land both you and your company in hot water. In the last couple of years, the IRS has engaged in an audit initiative involving executive compensation and fringe benefits. The focus began with large corporations and has now moved to smaller companies, too.
“Executive compensation has evolved dramatically in recent years, in creativity, complexity, and dollar value,” the IRS states on its website.
For example, stock options, deferred compensation, fringe benefits, and other “non-cash” alternative forms of compensation are becoming increasingly popular and making up larger parts of executives’ overall compensation packages.
During these types of audits, the IRS may scrutinize both the employers that pay compensation and the executive-employees who receive it.
When IRS auditors examine tax returns, they come well armed. Over the last 15 years, the IRS has developed a series of Audit Technique Guides, designed to bring its examiners up to speed on business practices which are common to specific industries, such as construction and gas retail.
Several other audit guides have been published to focus on broad issues that affect many industries, such as “Executive Compensation – Fringe Benefits.” In this guide, the IRS instructs auditors how to assess whether the proper tax was paid on common perks provided to executives.
Where Auditors Look for Errors
The IRS is aware that “corporate executives often receive extraordinary fringe benefits that are not provided to other corporate employees.” These potentially taxable fringe benefits, include property or service that an executive receives in lieu of, or in addition to, regular taxable wages.
That’s where problems can begin.Although it is clear that some fringe benefits are taxable, the IRS tells auditors that employers may classify them “under expense accounts other than compensation,” in order to avoid income and employment taxes.
Take corporate credit cards, for example. Although many companies provide them to executives and other employees, the process for reimbursement is different. The IRS audit guide notes that some “top level executives are permitted to use the card at will,” with monthly statements mailed directly to the corporation and the account paid in full without the submission of business expense reports. Lower level employees are generally required to submit expense reports before being reimbursed for business related expenses.
Auditors are instructed to look for personal expenses paid by credit card on behalf of executives and ensure these taxable fringe benefits were included in their wages.
The IRS audit guide recommends auditors begin a fringe benefit examination with a three-step process:
Assume a particular benefit is taxable to the executive.
Then, look to see if there is any statute which allows the benefit to be excluded from taxation. For example, does it qualify as a tax-free “working condition fringe benefit?”
Finally, if there is no statute that excludes the entire amount, determine the value of the benefit to include in the executive’s gross compensation. “Fringe benefits are generally valued at the amount the employee would have to pay for the benefit in an arm’s length transaction” the IRS explains.
If you do get audited, you may have to undergo a rigorous IRS review. Here are some of the steps the IRS recommends auditors take in examining executive compensation and fringe benefits:
Request a list of corporate executives and officers to identify the highly compensated employees. Determine who is responsible for approving and processing payments to them.
Review the minutes of meetings concerning executive compensation. Look for decisions and instructions about the treatment of fringe benefits. Identify all payments to, or on behalf of, executives and officers.
Inspect employment contracts and severance agreements to identify salaries and benefits.
Examine loan agreements between the corporation and executives and officers.
Check samples of monthly expense reports submitted by executives.
Search accounts payable records for the names, titles, and Social Security numbers of executives, in order to determine if payments made to them were included on their Forms W-2 or 1099.
Examine any documents filed with the Securities and Exchange Commission, such as Form 10-K, to identify compensation issues.
Ask for a list of payroll codes or other accounting codes which might be used for executive expenses, in order to identify payments which may be taxable.
Look at certain items on the tax return to see if fringe benefits have been claimed. For example, under Travel and Entertainment, Schedule M-1, Rent, and the line item “Other Deductions.”
When it comes to executive compensation, getting the details right and staying in compliance can be a daunting task. Consult with your tax adviser to ensure your company’s executive compensation plans are in line with the Internal Revenue Code and the regulations set forth by the IRS.