Preparing for an IRS Executive Compensation Audit

Employee Benefits Alert

The Large and Mid-Size Business (“LMSB”) division of the IRS announced late last year that it is incorporating the experience gained from its 2003-2004 executive compensation pilot program in its “package audits.” Specifically, LMSB audits will routinely focus on executive compensation arrangements, including deferred compensation, stock-based compensation, fringe benefits and other issues involving executive compensation. These audits, which essentially came about as a reaction to headline-making corporate governance and compensation controversies, can consume considerable company resources, including employee time and advisor costs, and can result in additional taxes, penalties, and interest. Compounding the expense and inconvenience involved in an IRS audit of the employer’s executive compensation programs, IRS agents are also examining the individual returns of selected executives. In response to the continued audit initiative, Miller & Chevalier has formed an Executive Compensation Compliance Team as described further below.

What to expect in an executive compensation audit:

IRS officials have publicly stated that, given the degree of noncompliance uncovered during the IRS pilot program, executive compensation audits will focus on deferred compensation arrangements, stock-based compensation, Code section 162(m) compliance, and fringe benefits. Other areas of concern include parachute payments under Code section 280G and split-dollar arrangements. Provided below is a brief summary of the principal areas that the IRS is likely to examine in most cases and what documents the IRS may ask to review. Deferred compensation arrangements: IRS examiners are likely to review the timing of when such payments are deductible by the employer as well as the employer’s procedures with respect to deferral and distribution elections. IRS audit procedures instruct examiners to request and review plan documents, election and distribution forms, employment agreements, bonus and deferral agreements, severance arrangements, payroll tax returns, and any employer records pertaining to the employer’s compliance with the employment tax requirements (FICA taxes, FUTA taxes, and income tax withholding) for any amounts deferred or paid out. According to one IRS executive, audits of plans covered by new Code section 409A are “probably a year or two away.”

Fringe benefits: Audits of fringe benefit plans are likely to focus on identifying what fringe benefits are provided to executives, whether such benefits are properly tracked, valued, substantiated (as required), deducted and reported, and whether the employer is utilizing any exclusion provisions correctly and/or treating the fringe benefit correctly for payroll tax purposes. IRS audit guidelines set forth the most common perks that invite scrutiny, including personal use of corporate cars and aircraft (and other “listed property”), cellular phones, skyboxes, spousal travel, and wealth management services. IRS examiners are also directed to review how such fringe benefits affected compliance with the deduction limit under Code section 162(m).

Stock-based compensation arrangements: IRS examiners are directed to determine whether the applicable requirements for any incentive and nonqualified stock options have been met, as miller & chevalier 2 well as whether employers have followed the arrangement’s vesting schedules and other plan terms. IRS audit procedures advise auditors to review the applicable SEC documents, the individual plans and award agreements, company policies, and the minutes of any compensation committees. Audits of nonqualified stock-based programs will also examine whether employment taxes were properly withheld, timely deposited, and reported.

Section 162(m) compliance: IRS auditors will focus on when the applicable performance goals were set, whether goals were met when payments were made, and whether performance goals were objective. IRS audit guidelines suggest review of the bonus or compensation plan documents, compensation committee meeting minutes, and whether proper records have been kept.

What employers can do now:

An employer can avoid or minimize the risk with many of the issues that would otherwise arise in an IRS audit of the employer’s executive compensation arrangements by engaging in a coordinated compliance review of its own programs. Even more importantly, employers who plan ahead for an IRS audit will save significant amounts of employee time and resources that the IRS would otherwise consume with voluminous document requests should an audit be initiated. Advance planning steps would include: (1) establishing an inventory of all executive compensation arrangements, including fringe benefits and individually negotiated arrangements (such as employment agreements); (2) organizing the documentation accompanying each particular arrangement (including plan documents and securities filings); (3) tracking and documenting the administration of each arrangement; (4) reviewing, revising and/or preparing fringe benefits policies; (5) reviewing the employer’s “accountable plan” and travel expense reimbursement procedures; and (6) working with either in-house or outside counsel to identify potential employee benefits and employment tax issues and evaluate corrective steps.

Miller & Chevalier Executive Compensation Compliance Team:

With its broad experience in executive compensation, fringe benefits, employment taxes, and IRS audits and controversies, Miller & Chevalier’s Executive Compensation Compliance Team can help employers conduct their own executive compensation compliance review for purposes of identifying and addressing outstanding issues and developing policies in anticipation of a possible IRS examination. This team’s experience in handling IRS audits and controversies gives it the ability to quickly and efficiently work with internal tax personnel and legal counsel in helping to identify and address potential issues and to prepare the employer for what might be expected during the IRS examination process.

For additional information, please contact any of the following lawyers:

Marianna Dyson,, 202-626-5867

Michael Lloyd,, 202-626-1589

Fred Oliphant,, 202-626-5834

Anthony Provenzano,, 202-626-1463

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