A fresh look at executive pay: review your executive compensation plans to make sure they comply with tax rules and mesh with your company's business principles

HR Magazine, May, 2005 by Betty Sosnin

If ever there was a time to put your company's executive compensation plans under a microscope, it is now.

For several reasons. HR professionals should have their companies' executive compensation arrangements reviewed for legal compliance and administrative accuracy. A thorough, professional review could uncover a need to realign executive compensation with altered goals and circumstances within the company, for example. It could also help ensure that the company is complying with the requirements of the Sarbanes-Oxley Act on corporate governance. And by identifying and fixing problems before they become public issues, a review can stave off negative publicity.

One of the strongest incentives for reviewing how your company pays top executives, however, is the prospect of an Internal Revenue Service (IRS) audit. Over a year ago, the agency launched a pilot program of examining executive compensation arrangements for tax-reporting irregularities. The initial focus was on large corporations, but now the agency's spotlight is turning to smaller companies as well.

In turn, some experts say HR professionals should get executive compensation reviews under way. It would be "a timely, precautionary move," says Paul Dorf, managing director of Compensation Resources Inc., an HR and compensation consulting firm in Upper Saddle River, N.J. "An IRS audit could prove expensive and embarrassing. An internal review will let you prepare for this and bring your plans into line. Companies are fooling themselves if they don't address this issue and do it on a consistent basis."

Consultant Chris Lipski, who has helped several companies through IRS audits of executive compensation plans and has performed internal reviews for others, says many of the problems the IRS is identifying stem from poor plan administration rather than plan design. Lipski, a Cleveland-based partner in the human capital practice of Ernst & Young, the global tax and auditing firm headquartered in New York, says executive compensation reviews can root out operational defects and design flaws and correct any areas of noncompliance. "Don't assume that your plans are in good shape just because they were developed by a competent attorney," he says. "You also have to make sure they are being administered properly."

Following Up On the News

The IRS began its pilot program, involving two dozen major corporations, in October 2003. "We were seeing a lot of noncompliance in the area of executive compensation coupled with scandals and media attention," says Keith Jones, director of field specialists for the IRS's Large and Midsize Business Division, which is leading the audit program.

The IRS's goal, Jones says, was to bolster compliance with tax rules by, for example, ensuring that companies' corporate tax deductions for executive pay (on Form 1120) match the income they report on executives' W-2 forms. "If you take the deduction," he notes, "someone else has to pick it up as income."

Another reason for the IRS's auditing program-and for HR leaders to initiate reviews of their companies' executive compensation arrangements--is the American Jobs Creation Act of 2004. The law made sweeping changes in the income tax treatment of nonqualified deferred compensation plans. ("Nonqualified" refers to how a plan is treated under IRS rules.)

The changes, which took effect in January, apply to most of those arrangements, including employment contracts. The law affects, among other things, supplemental executive retirement plans and certain nonqualified stock option plans. (They do not apply to tax-qualified retirement or similar plans or to standard stock option or employee stock purchase plans.)

"Since the act virtually invalidated most nonqualified deferred compensation agreements," Jones says, "we thought it was a good time to focus on executive compensation and identify problem areas or misunderstandings through a compliance initiative project."

The Audits' Rippling Effects

The IRS's pilot program has had widespread impact. For example, most of the audited companies "owed back taxes and had to file amended returns," Jones notes. In fact, says Lipski, some companies "lost tax deductions in the tens of millions of dollars."

"We found companies violating tax codes on everything from golden parachutes to the use of corporate planes," says Jones. Specifically, the IRS found instances in which companies had incorrectly accounted for deferred compensation on financial statements, allowed executives to collect deferred compensation before the agreed-upon date without tax consequence, and changed targets for executives' performance-based pay during a fiscal year without board or shareholder approval.

Some executive compensation problems developed simply because of poor internal communications, Jones says. "We found that companies sometimes have good plans, which HR is following, but the payroll department isn't withholding the right amount of tax."

Because of these discoveries, the IRS's effort is being extended. "As a result of the pilot program's findings," Jones says, "executive compensation reviews will now be embedded in our everyday procedures. We are training 70 employment tax specialists and more than 5,000 field agents to evaluate compensation practices more fully."