Executive compensation has been under scrutiny on several fronts in recent years.
The Financial Accounting Standards Board guidance on expensing stock options has become effective for public companies, in spite of legislative efforts to prevent the guidelines from coming into effect. The Securities and Exchange Commission and New York's attorney general have been investigating compensation received by executives without board approval or shareholder disclosure. The Internal Revenue Service has been targeting tax shelter schemes designed to permit executives to delay or escape payment of taxes on compensation.
New laws and regulations have accompanied this additional scrutiny. The Sarbanes-Oxley Act of 2002 prohibited loans to officers and directors. Such loans had sometimes been used as a disguised form of compensation. The new restrictions have brought into question some companies' long-standing policies of cash advances to executives to accommodate stock purchases, corporate moves, etc. The new restrictions have even brought into question the availability of 401(k) plan loans to officers and directors.
The American Jobs Creation Act of 2004 tightened up the rules for nonqualified deferred compensation, imposing new restrictions on distributions, acceleration of benefits, elections and funding. The act also added a provision to prevent the deduction of corporate expenses with respect to executives, unless those expenses were included in compensation by the employee and subject to withholding.
Several recent developments continue this trend of scrutiny of executive compensation in the tax shelter and fringe benefit areas.
Stock option shelter
One of the tax shelters that the IRS has identified as abusive involves the transfer by executives of their stock options to family-controlled partnerships. The promoters of these shelters claimed that they permitted an immediate deduction to the corporation paying the compensation, but a potential for a long deferral of tax payments by the executive who was entitled to the options.
In February 2005, the IRS announced a settlement initiative concerning these transactions, having identified many of the participants through discovery from the promoters. The terms of the settlement required full and immediate payment of the income and employment tax and interest, but reduced the penalty normally due from 20 percent to 10 percent.
The IRS recently announced that 95 of the 114 executives identified had agreed to settlements with the IRS. Eighty of these executives agreed to the settlement terms, and the other 15 reached settlements during pending audits. Of 42 corporations identified as involved in the transactions, 33 elected to participate in the settlement.
The 19 identified executives who did not reach settlements will now face audits and criminal proceedings. Although the 19 executives declining to participate represent only just over 15 percent of the total number of executives identified, many of them appear to have a lot of dollars at stake, as they represent close to 45 percent of the total dollars identified as involved in these shelters.
One advantage of settlement with the IRS appears to be that the corporations and executives who settled may not be identified, while the names of the corporations and executives who become subject to criminal proceedings will be identified in public.
Section 907 of the Jobs Act provided that, in the case of specified individuals, entertainment expenses for goods, services or facilities are deductible only to the extent that the expenses do not exceed the amount of the expenses that are treated by the employee as compensation subject to withholding. Under a 2001 Tax Court case, Sutherland Lumber, employers were able to take a larger deduction for employee use of company-owned aircraft than the employees had to include in income.
Notice 2005-45 specifies the calculations that must be used to the amount of potentially disallowed deductions with respect to company-owned aircraft, based on either occupied seat hours or occupied seat miles flown. The new guidance must be used for expenses incurred after June 30, 2005; however, some transition rules are also included in the guidance.
The specified individuals to which Section 907 applies include officers, directors and owners of at least 10 percent of the company. However, a provision in the Senate version of highway funding legislation, currently before a House/Senate conference committee, would expand this provision to apply to all persons, including non-employees.
As employers load down their executives with laptop computers, cellular phones and Blackberries, the personal use of these devices is coming under increased IRS scrutiny. Cellular phones are a particular IRS focus, since the phone log provides a readily available guide to IRS agents as to the degree of personal use. Identification of personal use can result not only in additional compensation income to the executive, but also additional employment taxes due from the employer.
Companies and their tax advisors are starting to address this potential exposure by either forbidding personal use of company-provided electronic equipment, or tracking personal use and treating it as compensation. Electronic equipment provided to employees will have to come to be viewed in much the same way that company-provided automobiles are viewed, with policies in place with respect to personal use.
Executive compensation is an area that tax practitioners will have to closely monitor. While it is a particular concern with publicly held companies, private companies and tax-exempt organizations and their advisors will also have to keep abreast of developments in the area to keep their clients out of trouble with the IRS.
George G. Jones, JD, LL.M, is managing editor, and Mark A. Luscombe, JD, LL.M, CPA, is principal analyst, at CCH Tax and Accounting, a WoltersKluwer company.
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