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Overview

The IRS publication of a new audit techniques guide for their auditors is both reason for celebration — and panic. On one hand, it provides a perfect roadmap of exactly what the IRS auditor is looking for, and how he or she will go about doing so. Which, in turn, tells you what you can do, what not to do — and how to do it. On the other hand, publication of such a guide virtually assures you that there is an IRS crackdown coming in the particular area of their latest such publication. The exact title of this new guide should leave no doubt in your mind: Executive Compensation — Fringe Benefits Audit Techniques Guide. Select the various parts of this article that apply to you — and learn what the rules are — and how the IRS will audit that area. Then, like the Boy Scouts, be prepared.

Don’t assume because of all the Tyco, WorldCom and similar publicity, that this new audit emphasis will only address large public corporations. While it assuredly will do so because of the many, many abuses that have come to light — the IRS also has another view of whom to audit. They also feel that in the case of small non-public corporations, there is also a major possibility for “tax abuse.” Because in the latter situation you have few or single stockholders (no accountability to the public) and a sometime attitude that the corporation and owner are one and the same. So, the new audit emphasis may hit corporations of any size — public and private — and both C and S corporations.

The IRS Guides Their Auditors — and Our Readers

Some of the preliminary comments from the Guide lay out the IRS opinions and audit plans clearly. To use current slang, just “listen up” to the IRS quotes:

Corporation executives often receive extraordinary fringe benefits that are not provided to other corporate employees. Any property or service that an executive receives in lieu of or in addition to regular taxable wages is a fringe benefit that may be subject to taxation.

Whether a particular fringe benefit is taxable depends on whether there is a particular statutory exclusion that applies to the benefit.

Although it is clear that fringe benefits are taxable, employers may not treat them as wages for income and employment tax purposes. Employers may classify a taxable fringe benefit under expense accounts other than compensation, resulting in failure to subject the fringe benefit to income and employment taxes.

The IRS then suggests a 3-step analysis of any fringe benefit provided the executive:

• First, identify the particular fringe benefit and start with the assumption that its value will be taxable compensation to the employee.
• Second, check to see if there are any statutory provisions that exclude the fringe benefit from the executive’s gross income.
• Third, value any portion of the benefit that is not excludable for inclusion in the executive’s gross income. Fringe benefits are generally valued at the amount the employee would have to pay for the benefit in an arm’s-length transaction.

Finally, they end up their preamble with this summary, after cautioning again that there are both income and employment tax issues that apply to fringe benefits:

• Is the expense deductible by the corporation?
• Is the amount excludable from the gross income of the executive?
• Is the executive receiving personal benefit from the corporation?
• Does the benefit exceed the $162(m) limitation?

That certainly lays it out for you as to the overall IRS intentions. Now, let’s discuss specific fringe benefits as to what the law is, what they will do, and what you should (or should not) do.

Corporate Credit Cards

The IRS Guide cautions that top-level executives are generally permitted to use corporate credit cards “at will.” Then it tells the auditors the following:

Determine if the corporation has an “accountable plan” for the executives (which requires exact substantiation of each business expense). If the executive is not required to substantiate, the entire reimbursement or charge is taxable to the executive as additional wages.

Personal expenses paid on behalf of executives (of course) should also be included in wages.

Loans to Corporate Executives

The IRS position is that frequently such loans are “disguised compensation.” They question “low-cost” and “no-cost” loans particularly, as well as any loan that does not meet their conditions for a bona fide loan:

• Existence of a promissory note.
• Cash payments of principal according to a specified repayment schedule.
• Interest is charged (and paid).
• Interest charged is not at “below market” rates.
• There is security for the loan.
• The loan should be on the corporate balance sheet as a receivable.
• Do the loan terms include any forgiveness if the executive remains with the company for a certain number of years (or leaves the company)?

Of course the last two conditions may be indications that there was “forgiveness of the indebtedness,” which is taxable income to the executive. As the Tyco, WorldCom and other similar cases highlighted — sometimes tens of millions of dollars were never reported by the executives, as the various corporations forgave those huge loans to executives.

CAUTION: For public companies only: the Sarbanes-Oxley Act, bans all new loans to officers and directors, effective July 30, 2002. The law (familiarly called “SOX” by many tax advisors) does not apply to private companies.

A final quote from the IRS Guide on this matter: “Some loans to executives are essentially disguised compensation based on the terms of the loan… gross income includes compensation for services and income from discharge of indebtedness.”

Automobiles

As we all know (or should know), personal use of a business auto is always taxable to the individual. The IRS position has always been that trips from home to the office and returning to your home again are always taxable personal use (“commuting”), in addition to all other non-business use.

(There is an exception to the office-commuting rule if your only office is in your home.) As stated in the Guide, the amount of all personal use is either fair market value, or figured under one of these special IRS methods (see your tax advisor for explanations):

• Auto lease valuation.
• Vehicle cents-per-mile.
• Commuting valuation.

So the IRS auditor will always look for some of that taxable personal-business-auto use….

Employee Use of Listed Property

Special recordkeeping requirements apply to “listed property,” which includes business autos (see above), business computers used at home, and all cellular phone use. The IRS requires: “detailed records to establish the business use” of those items. As we have often written, other than autos, this requirement borders on absurdity. Many executives just “eat” the estimated personal use costs of home computers and cell phones if they are audited.

Can you picture a salesman making multiple cell phone sales calls, who then stops to record one personal call to his spouse? And particularly while driving? Or similar recordkeeping for that business computer legitimately used at home? This is just unrealistic overkill — but it’s the law.

Transfer of Property

Again from this Audit Guide:

“Remuneration may also take the form of property. Property other than cash may be represented in a number of forms. It may include stock or personal property including real estate, furniture, equipment, personal computers and/or cellular phones. Executives generally maintain a home office that may be furnished by the corporation. Sometimes upon termination of employment the furnishings and equipment are transferred to the executive as part of the severance package.”

Boy, are they suspicious! Imagine getting real estate without it being reported as income or stock in the company? Well, it must have happened more than once to get included in the section of the Guide. So all of the above is what they will be looking for — and where do I apply for my free home?

FICA Taxes

If the employer pays the employee’s share of FICA taxes — that itself is considered as additional wages, subject to both income taxes and employment taxes. This may typically occur when there is a taxable fringe benefit (although we have heard of it in other situations). So sayeth the Guide….

Club Dues and Memberships

Since 1994, no deduction is permitted for club dues. This includes all kinds such as: social, athletic, sporting, luncheon, airline, hotel and “business” clubs. When the employer pays the dues of an executive, the choice is to either: (a) include the club dues as additional income to the employee, or (b) the employer cannot claim any tax deduction for the club dues paid (a Schedule M adjustment on the corporate tax return).

The skeptical Guide then adds the following caution: “Club memberships have been distributed to departing executives through severance agreements. The value of a club membership distributed to executives upon departure is wages. Close scrutiny should be afforded employment contracts and severance agreements for executives.” Really cynical.

Awards/Bonuses

Again I will let the Guide speak to you:

“Awards and/or bonuses paid to key executives should be carefully reviewed to determine if they should be included in remuneration….Corporations have begun providing non-cash awards and bonuses to executives. It may be necessary to review invoices for the ‘ship to’ address for large ticket items that appear personal in nature.”

Relocation Expenses

Only the costs of: (a) moving personal belongings and (b) traveling to a new location, can be paid or reimbursed tax-free to the executive. The Guide advises the auditor to look for other paid moving expenses that are not tax-free to the employee, such as:

• Reimbursement for losses with respect to sale of the prior home.
• Brokerage fees, property taxes, insurance, fix-up expenses and similar.
• Costs of lodging in temporary quarters after the move, including meals.

Spousal or Dependent Travel

The Guide reiterates the established rules that: “no deduction shall be allowed (the company) for travel expenses paid or incurred for spouse, dependent, or other individual accompanying the executive on business travel unless:”

• The spouse, dependent, or other individual is an employee of the company, and
• The travel of the spouse, dependent, or other individual is for bona fide business purposes, and
• The expenses would otherwise be deductible by the spouse, dependent or other individual.

That’s been the law for quite some time. If you cannot meet those conditions, such expenses are considered additional wages to the executive.

Employer-Paid Vacations

Surprise! The IRS takes the position that vacation expenses are personal expenses! If paid by the company, they represent additional wages to the employee. This includes transportation, meals and lodging. Their further advice is for the auditor to check if such expenses are “buried” under such accounts as: Travel and Entertainment, or Employee Benefits, or Other Deductions.

Luckily, our clients almost never take vacations. They only travel entirely for business….

Qualified Retirement Planning

Counseling employees and their spouses about their retirement planning is a tax-free fringe benefit to employees and tax-deductible by the corporation. However, the employer may not discriminate in favor of highly compensated employees! The rule states that “…the exclusion is allowable for highly compensated executives only if the retirement planning services are available on substantially the same terms to each member of the group of employees normally provided education and information regarding the employer’s qualified employer plan….”

Otherwise, the IRS auditor will hit those top executives with additional income.

As an aside, we feel strongly that if the company can afford these services, they should be provided to all employees — and their spouses (who usually don’t have a clue as to what’s going on in this area and frequently are more practical about retirement planning than their mate). Just our opinion.

Wealth Management

There is no tax-free exception as with the preceding benefit. The Guide says: “As part of their employment agreement or as a separate written or oral agreement, many executives are provided either a sum of money for financial planning or the services of the accounting firm used by the company. The use of financial planning services is a service that an executive receives in lieu of compensation and is a taxable fringe benefit….”

Athletic Skyboxes/Cultural Entertainment Suites

The amount allowable as a tax-deduction by the corporation is limited to the face value of non-luxury box seat tickets times the number of seats in the luxury box. Entertainment expenses in the box are limited to: (a) accounted for business-related entertainment and (b) then at only 50% (IRC 274). Personal use of the luxury box by executives is, of course, taxable income to the individual, and that’s what they will be looking for. (In our firm, the only “boxes” we have at sporting events are rather small…and usually contain buttered popcorn.)

Employer-Paid Parking

The value of parking provided to an employee on or near the business premises of the employer is a tax-free fringe benefit to the employee, provided the statutory monthly limit is not exceeded. For the year 2005 that monthly limit is $200. In major cities and in top office buildings, that $200 could be regularly surpassed (particularly with reserved or valet parking). Of course the excess over $200 is taxable income to the executive. (In our humble office building, each employee could park about three cars before they exceed that $200 limit.)

Conclusion

One of our clients who saw this IRS publication had a totally different reaction. He said, “Wow! This is great! You can really pick up a lot of good ideas in there about things to do to cut taxes.” We hope he was kidding.