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COPYRIGHT 2004 Aspen Publishers, Inc.
The Internal Revenue Service has announced that it is undertaking extensive audits of executive compensation. This follows on the heels of a pilot program in which the IRS scrutinized carefully the executive compensation practices of 24 chosen companies. As discussed in more derail below, as part of its expanded review, not only will IRS corporate auditors ask specific questions about executive pay and practices, but executives may be required to provide copies of their personal tax returns for review. These activities go hand in hand with other activities of the IRS in policing what it considers aggressive executive compensation practices, such as the issuance of notices making certain of these practices "listed transactions" subject to increased disclosure requirements and potential penalties.
Although cynics might argue that the IRS is merely joining the bandwagon of state attorneys general, shareholder advocates, and Congress attacking executive compensation, such activities should prompt any officials responsible for executive pay--including human resource and tax officials--to take a look at their current executive compensation policies and to warn executives in advance that their own personal returns may be subject to increased scrutiny. They should also be aware that unlike the past, a confluence of events--in particular, the publicity about the corporate pay practices at Enron and other companies--has created an atmosphere in which the IRS may be able to attack certain executive compensation practices without fear of extensive interference by Congress. This same dangerous atmosphere, however, might also provide an opportunity for human resource managers and other advisers to convince corporate executives that enhanced record keeping and approval processes for their compensation is important and appropriate.
A Bit of Background: "Traditional" Practices Prevail
Executives are often engaged in a tug-of-war with their corporate employers and the IRS because they want to maintain control over the amount and timing of their pay and benefits, but they do not want to be taxed on those benefits. For over three decades, the IRS has sparred with taxpayers over the extent to which an employee could change or secure the deferred compensation promise made to him by the employer. Both Congress and the courts have made it difficult for the IRS to enforce its views of the "proper" treatment of executive compensation, particularly deferred compensation and executive fringe benefits. In some cases, the IRS's position appears to have been more conservative than the courts have required. Pressure from Congress has often caused the IRS to soften proposed regulations that would govern the tax treatment of employee fringe benefits.
Modification of Deferred Compensation
Common practices allowing employees to modify their deferred compensation arrangements without income inclusion are based on court cases (which the IRS has unsuccessfully contested) holding that modifications of compensation arrangements could occur without causing income recognition at the time of change as long as such modifications occur before the deferred compensation is scheduled to be paid. For example, in Oates v. Commissioner, (1) the court allowed a modification of a payment schedule for the taxpayer three days before payments would begin. In Veit v. Commissioner, (2) deferrals of profit sharing payments from one year to a later year were permitted without current income taxation.
The IRS attempted in file 1970s to issue proposed regulation 1.61-16 that would have altered the practices arising from these cases. That regulation would have currently taxed compensation that could be deferred pursuant to an employee's election. In response, Congress enacted section 132 of the Revenue Act of 1978, which prohibits any changes to the deferred compensation rules as they existed in 1978. After the passage of the 1986 Tax Reform Act (which reduced rates prospectively), the IRS issued Announcement 87-3 stating that it would closely scrutinize agreements designed to defer income until later, lower-rate, tax years. The IRS warned that if such short-term deferrals lacked substance, the taxpayer could be treated as "in constrictive receipt" of the deferred amount.
The courts have continued to rebut the IRS's position that employees who elect to change the timing of their deferred compensation promises have "constructively received" such compensation by virtue of that election and thus should be currently taxed. In Martin v. Commissioner, (3) the IRS unsuccessfully challenged modification of deferred compensation agreements where the amount due was not yet payable. An IRS-generated internal technical advice memorandum leading up to Martin (4) had argued that a modification of a deferred compensation plan resulted in constructive receipt of the amounts under the plan and attempted to distinguish Oates, Veit L and Veit II. In distinguishing Oates, the internal memo stated that since the payments were contingent on renewal commissions, nothing had been earned at the time of the election. The IRS tried to distinguish Veit I and Veit II by noting that in both cases the change in payment date was the result of "bilateral negotiations," although the courts did not emphasize these factors.
The IRS has maintained its unsupported position at the rating level and will not issue an advance ruling concerning the application of the constructive receipt doctrine to an unfunded deferred compensation arrangement unless the election to defer payment of compensation is made before the beginning of the "period of service for which the compensation is payable ..." (5) Nonetheless, many companies have relied on Veit. Oates, and Martin...
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