The Internal Revenue Service is taking steps to address significant perceived non-compliance by public companies with the tax law requirements applicable to executive compensation arrangements. As we have previously reported, the IRS undertook an audit initiative last year to evaluate the level of compliance in light of the increasing complexity and value of executive compensation arrangements. A senior IRS official has now reported that IRS discovered compliance failures during its initial audits ranging from non-reporting of compensation by executives to deficient corporate governance practices involving incentive payments, non-qualified deferred compensation, golden parachutes and executive perks. The official noted that these failures often occurred due to a lack of sufficient internal procedures notwithstanding the existence of plan documents that complied with applicable tax law. As a result of these findings, the IRS has announced it will be releasing new audit guidelines on executive compensation, in addition to the additional training it has already begun to provide its agents. Separately, the Treasury Department has indicated support for legislation that would allow the IRS to share with the Securities and Exchange Commission any confidential information discovered during audits.
These developments underscore the importance of immediate action by public companies to evaluate their level of audit readiness on executive compensation. Improper reporting of compensation by senior level executives may impair their ability to lead or even remain with the company. Last year, it was reported that the chief executive officer of a major publicly-traded company was forced to resign after the IRS discovered during an audit that the CEO had engaged in a stock option sale transaction with a family limited partnership that is now a listed tax shelter. Deficient executive compensation practices can damage a company’s reputation generally and adversely affect its credibility with investors, overcoming efforts to project a “best practices” profile by extensive and expensive compliance efforts with requirements of the Sarbanes-Oxley Act. It is reasonable to expect that the SEC will investigate any public company upon learning that the IRS has discovered improper actions that raise corporate governance and proxy disclosure concerns.
It is important to note that tax liabilities that may result from an IRS executive compensation audit can be significant. Failure to comply with the performance-based requirements under Section 162(m) to deduct incentive compensation may result in millions of dollars in lost tax deductions in addition to raising questions regarding the Compensation Committee’s report in the company’s proxy statement. Failure to comply with the Section 162(m) requirements can easily result from the operational failure to comply with well defined, mechanical rules that are relatively straightforward for an agent to apply in an audit. Similar tax exposures to public companies can also exist with respect to aggressive efforts to avoid “golden parachute” penalties under Section 280G.
The IRS will use the information it has gleaned from its executive compensation compliance initiative in its “routine” corporate tax audits of other large and mid-sized businesses. According to the IRS’ top executive compensation officer, now is “a good opportunity” for corporations “to go back and take a look at their arrangements and make sure that the rules are being complied with themselves.” The IRS advises that “there are certainly opportunities to make fixes before the Service comes in.”
We recommend that public companies act upon the IRS’ suggestion and evaluate their executive compensation arrangements. A compliance review will enable a public company to become audit ready and to address compliance issues before an IRS audit commences. As noted by the IRS, it is not enough that plan documents comply with tax requirements. The actual operation of the plans must also be properly coordinated between the general counsel, tax, human resources and finance departments. We have compiled many of the questions and document requests developed by the IRS as part of audits and training materials, which should form the basis of a compliance review.