irs audit activity involving executive compensation and benefits · 7 irs executive compensation...
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IRS Audit Activity InvolvingExecutive Compensation and Benefits
ABA Tax Section (EO Committee)
Midyear MeetingJanuary 21, 2011
Ralph E. DeJong, Esq.
McDermott Will & Emery LLP
rdejong@mwe.com
Robert W. Friz
PricewaterhouseCoopers LLC
robert.w.friz@us.pwc.com
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Executive Compensation Still a Major Area of Concern
� Broader context is qualification for federal tax-exempt status,
particularly for charitable hospitals
� Executive pay and benefits still make headlines
� Sen. Grassley wanted tighter rules, but PPACA ultimately
included non-pay-related exemption requirements for
hospitals
3
Executive Compensation Still a Major Area of Concern (Cont’d)
� Form 990, as revised, provides more detail, but confusion
continues
– Double counting deferred compensation
– Disparate reporting practices
– Comparing pre-2009 and post-2007 Forms 990
– Difficult to link numbers and narrative explanations
4
IRS Executive Compensation Activity
� 2004 “soft contact” questionnaires included questions on
executive compensation
– Frequent unreported items
– Generally addressed through prospective changes in 990 reporting
� 2007 report on IRS findings
– Primarily focused on 990 reporting noncompliance
– Some concern as to loans
5
IRS Executive Compensation Activity (Cont’d)
� 2006 Hospital questionnaires included an executive
compensation section
– Conflicts of interest involving approval body
– Comparability data
� 2009 report on hospital project
– Nearly all hospitals responding used rebuttable presumption process
– 20 hospitals were audited, but pay was found to be reasonable
6
IRS Executive Compensation Activity (Cont’d)
� 2008 compliance check questionnaires, sent to 400 public
and private colleges and universities, included questions on executive compensation, types of executive benefits, and
review and approval process
� 2010 interim report on colleges and universities project,
noting follow-up audits being conducted at more than 30 of
the 400 institutions involved
7
IRS Executive Compensation Activity (Cont’d)
� 2010-12 employment audit program
– 2,000 employers per year for three years
– Includes roughly 1,500 EOs
– Focus on employee (vs. independent contractor) status, executive
fringe benefits, executive pay, and payroll tax compliance
� Combined Annual Wage Reporting (CAWR) Project
– IRS analysis of employment tax reporting by EOs for 4,000
organizations from FY 2007 – 2010
– Included focusing on reporting of officer compensation on Form 990
with no Form W-2 reporting
8
What Are the Risks?
� Challenge to exempt status based on private inurement or
more than insubstantial private benefit
– Corporate income tax liability
– Financial reporting considerations, including FIN 48 (ASC 740-10)
� Intermediate sanctions excise taxes on disqualified person
who received an excess benefit from a 501(c)(3) or (c)(4)
entity
� Automatic excess benefit transaction for any economic benefit (to a disqualified person), if the organization did not
clearly indicate its intent to treat the benefit as compensation
at the time of payment
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What Are the Risks? (Cont’d)
� Penalties for failing to report, withhold as to, and pay
employment taxes as to, economic benefits that should have been treated as taxable compensation
Key Audit Issues / Observations
� Automatic Excess Benefit Transactions - accountable vs.
non-accountable plans
– Accountable Plan Requirements
– Business connection
– Substantiation
– Return of any amounts in excess of substantiated
expenses
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� Automatic Excess Benefit Transactions - accountable vs.
non-accountable plans
– Non-accountable plan reimbursements generally implicate
– Form W-2 and Form 941 reporting
– Withholding and payment of employment taxes
– Form 1040 reporting
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Key Audit Issues / Observations (cont’d)
Key Audit Issues / Observations (cont’d)
� Automatic Excess Benefit Transactions
– Intent to treat reimbursements as compensation for
services
– Written contemporaneous substantiation
– Reasonable cause exception
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� Automatic Excess Benefit Transactions
– Key IRS focus areas
– Expense reimbursements not satisfying the strict
accountable plan rules
– Fringe benefits that may not be covered by a statutory
exclusion
– Loans to disqualified persons
– Existence of a bona-fide loan
– Imputed income issues for below-market loans
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Key Audit Issues / Observations (cont’d)
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Audit Issues Generally
� Identify who is at risk, whose issues are implicated, to whom
the audit is directed, and who is the client
– Note the disparate interests, in a 4958 case, of the entity and the
recipient
� Potential conflict of interest for legal counsel that previously
advised as to any item being challenged
� Application of attorney-client and attorney work product
privileges
– Consultant reports and/or reasonableness opinions prepared at
direction of counsel
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Audit Issues Generally (Cont’d)
– Counsel’s correspondence and/or risk assessments
– Drafts of final reports, opinions and correspondence
� Statute of limitations
– Which years are open?
– Normally a three-year period running from filing deadline for 990 on
which item is adequately reported
– If the contested issues have not been adequately reported on 990, a
six-year period applies
– An audit typically begins with a request to extend the limitations period
on open years being examined
16
Audit Issues Generally (Cont’d)
� Who defends? Check for applicable liability insurance and
rights of carrier to defend
� Bear in mind strategic options
– Requesting technical advice
– Showing reasonable cause
– Requesting abatement of certain taxes
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Issues Arising in Executive Pay Audits
� Reasonableness of total compensation process by which
review and approval occurred
� Whether rebuttable presumption applies
� Comparability of data used by approval body
� Particular types of pay or benefits
– Nonaccountable expense allowances (including any remaining flexible
benefit allowance programs)
– Club memberships
– Use of employer-owned housing
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Issues Arising in Executive Pay Audits (Cont’d)
– Personal use of other employer property (particularly corporate credit
cards and employer-owned or leased cars)
– Spouse/companion travel
– Broader business expense reimbursement (particularly issue of
adjacent personal time/activity)
– Other fringe benefits such as gift cards, tangible gifts, and post-
termination or lifetime health benefits
Key Audit Issues / Observations
Form 990 Focus Areas
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Key Audit Issues / Observations
20
Form 990 Focus Areas
Key Audit Issues / Observations
Form 990 Focus Areas
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Key Audit Issues / Observations
Form 990 Focus Areas
22
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IRS Requests for Information (“IDRs”)
� Describe process used to determine pay and benefits of
officers, directors, trustees, and key employees and five
highest-paid other employees
� Provide employment and other agreements between
organization and those individuals
� Provide minutes for all Board and committee meetings at
which executive compensation was discussed
� Provide all compensation consultant reports
24
IRS Requests for Information (“IDRs”) (Cont’d)
� Provide any correspondence, including emails, between the
organization and the compensation consultant
� Describe each executive benefit provided
� Provide all relevant governance documents, including
bylaws, committee charters, and governing policies
25
Typical Disputed Issues in Executive Compensation Audit
� Application of rebuttable presumption
� Whether use of for-profit data was appropriate
� Whether compensation consultant was independent
� Did market data represent “similarly situated” organizations?
� Whether reasonable compensation starts at the market
median
� Whether 990 data of other organizations should be used to challenge or defend compensation as reasonable
26
Typical Disputed Issues in Executive Compensation Audit (Cont’d)
� Whether use of employer-owned property was sufficiently
business-related
27
Preparing for Possible Audit
� Do meeting minutes clearly describe compensation and
benefits considered and approved, approval process, rebuttable presumption and basis for reasonableness
conclusion?
� Are all elements of pay and benefits, and all uses of
employer property, identified and known to the Board or
applicable committee?
� Is the authority of the applicable committee to review and
approve compensation, and to qualify for the rebuttable
presumption, clear?
28
Preparing for Possible Audit (Cont’d)
� Has organization identified and resolved all conflicts and dualities of interest involving members of the applicable committee, so that an actual or perceived conflict does not become a sticking point?
� Is the compensation consultant sufficiently independent?
� Has the organization reported everything on the 990 in a manner that will cause the statute of limitations to run?
� Whether or not the compensation consultant has opined on reasonableness, has the Board or applicable committee reached its own supportable and well-articulated conclusion as to the reasonable of compensation?
29
Preparing for Possible Audit (Cont’d)
� Is the full Board at least aware of all executive
compensation?
� Is the organization aware of when the “initial contract
exception” (to 4958 excise taxes) might apply, and is the 990
reporting consistent with the position?
� For any known excess benefit transactions, has a thorough correction been made (that will serve as a good defense to
an exemption challenge), and is the 990 Schedule L
reporting clear and consistent?
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Preparing for Possible Audit (Cont’d)
� Has the organization clearly stated which economic benefits
are intended at all times to constitute compensation (by contract, approval as compensation, or reporting on an
appropriate federal tax form), so as to avoid automatic
excess benefit transaction treatment?
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