IRS Employment Tax Audit Program Will Affect Taxation of Executive Compensation

In the past couple of weeks, the IRS began to mail audit notices to companies in its first major study of employment tax practices in 25 years. Even companies that are not targeted right away should be aware of the new program, and the shift it signals in the IRS’s posture toward executive compensation.

Last fall, the IRS announced that it will randomly select 2,000 businesses per year over the next three years for examination of their employment tax practices as part of the Employment Tax National Research Project. The IRS announcement says that the examinations “will be comprehensive in scope”. Over at Bloomberg, reporter Ryan J. Donmoyer confirmed that the examinations will include a detailed review of executive compensation tax practices for the subject companies.

Commentary. If your company is one of the lucky 2,000 selected for examination this year, you obviously have your work cut out for you. But if you don’t get a notice, why should you care about the IRS program? Because it signals a shift in IRS policy toward complex executive compensation taxation issues. Your friendly tax collector is likely to get less friendly when it comes to executive compensation.

Employers structuring executive compensation programs have to deal with the complex and sometimes fuzzy requirements of:

• Section 409A covering non-qualified deferred compensation; and
• Section 162(m), the cap on deductibility of some executive compensation of public companies.

Clients have often asked us about the risk of an IRS audit covering these and other executive compensation tax issues. Until now, there was very little evidence that the IRS was targeting these areas.

However, the IRS’s new initiative indicates that there may well be a new focus on compensation tax issues, and the initial 6,000 targeted companies will just be the first step. One of the main goals of the new initiative is “. . . to determine compliance characteristics so IRS can focus on the most noncompliant tax areas.” In other words, expect the IRS to use the information gathered in the study to get more aggressive with a broad range of companies in connection with specific practices under Section 162(m) and Section 409A.

Therefore, executive compensation professionals at public companies (and privately held companies as well) should be reviewing their compliance with executive compensation tax requirements with additional care.