Statements by a senior IRS official at the ABA’s Tax Section mid-year meeting on January 31, 2004, indicate that the IRS is continuing, expanding and strengthening its new Executive Compensation Audit Initiative. Focused on large- and mid-sized businesses (LMSB taxpayers), the IRS says the executive compensation audit initiative ends the “period of benign neglect” of executive compensation issues in order to confront the IRS’ finding of what it views as significant noncompliance involving executive compensation. In fact, the IRS admits that it is because of this prior “benign neglect” on its part that executive compensation noncompliance has occurred, even among the largest and most sophisticated companies.
During the first half of 2003, the IRS was actively but quietly implementing this initiative, training agents and selecting targets. After hearing rumblings of aspects of the audit initiative from various IRS sources, we first broke the story last summer about the formal audit initiative in an article in Corporate Governance that was then reprinted in Corporate Counsel Weekly, US Law Week and Corporate Accountability. The IRS publicly announced its coordinated and ever-expanding efforts in November 2003, indicating that it had initially targeted only 24 large companies as test cases. We have previously warned our clients that the audit initiative is likely to expand beyond the initial targeted list and, in fact, the IRS is now saying that its “year-long probe has shown a number of problems and abuses” and the IRS is forming the “infrastructure” to support expanding this examination program on a “wider basis.” The IRS is using its examination of the 24 LMSB taxpayers to establish its existing “knowledge base” regarding the targeted issues.
Subject areas currently targeted include nonqualified deferred compensation, executive fringe benefits, stock-based compensation, the million-dollar cap on deductible compensation, split-dollar life insurance benefits, golden parachutes and various executive asset protection arrangements. The list is likely to further expand. Furthermore, the IRS is making it clear that it is not stopping at plan document review, but that the IRS agents will also be looking at how the executive compensation programs, particularly those for top executives, work in practice. Perhaps most ominous of all, the IRS indicates that it is seeing examples of top executives using the company as a “piggy bank” and it again continues its warning that it intends to examine the income tax returns of top executives in conjunction with the corporate audits.
In light of the IRS’ increasingly public statements and broad assertions about the scope of the Executive Compensation Audit Initiative, it is recommended that companies conduct an internal review of their own executive compensation programs. The goals of such a focused compliance review are to identify and address any necessary issues, ensure consistency between practice and plan documentation and satisfy any available relief provisions. To facilitate such a compliance review, we have compiled a lengthy series of questions and document requests—the vast majority of which are based upon actual IRS training materials, prior audit inquiries, IDRs from the actual Executive Compensation Audit Initiative and/or conversations with relevant IRS contacts.