Accounting for the top earners

If your company is audited, chances are, the IRS will be very interested in how you accounted for executive compensation.

“If your company has executives, you’re dealing with rather substantial sums of money,” said Alan E. Weiner, a senior tax partner for Holtz Rubenstein Reminick, an accounting firm in Melville.

Keep in mind that rules concerning taxes are not necessarily the same as those affecting financial statements, Weiner said. Further, you must make sure you are in compliance with state laws in addition to federal laws. “It’s important to hire a competent accounting, law or employee benefits firm with expertise in tax. You can’t do this alone.”

During an audit, the IRS will ask to see copies of contracts that your company has with its executives, Weiner said. “One of the things the IRS will look at is at what point the executive was entitled to income, and at what point the employer is entitled to the deduction,” he said. The agent will also look to make sure the proper withholding amounts have been taken out.

“In the public arena, the big issues are with Code Section 162(m) and providing documentation that all of the components of the executive’s compensation have been properly included in the W-2,” said Raymond F. Kelly, a tax partner in the Melville office of accounting firm Marcum & Kliegman. “In private companies, the big concern is the classification of deductions that are considered business deductions, which the IRS reviews and reclassifies as compensation.”

Public companies

Under Code Section 162(m), a public company’s corporate income tax deduction is capped at $1 million per year for amounts paid to its chief executive officer and each of the next four highest-paid executive officers. However, the cap excludes performance-based bonuses as well as some fringe benefits and commissions – and therein lie the issues.

For executives earning more than $1 million, Kelly said, the IRS will want to see documentation that the company has properly included all of the items that are considered compensation, including the vesting of restricted stock, stock option exercises, and various other taxable fringe benefits or other executive benefits, such as company cars. “The IRS will also review documentation that demonstrates the limiting of the compensation deduction to $1 million on the company’s tax return,” he added.

The IRS will want to make sure a company is not fraudulently back-dating executives’ stock options. “The SEC has been very interested in this area for the past couple of years, and now it’s a hot issue for the IRS,” Kelly said.

“Senior executives often get stock options as part of their compensation package,” Kelly continued. “Say a company grants to Mr. or Ms. Executive the right to buy 1,000 shares of stock at $10 per share. Then the value rises to $20 per share and the executive exercises the option, and is taxed on the gain of $10 per share. A company gets a deduction based on this amount.” The IRS will want to see that the company did not back-date the records, say, by six months, to when the stock may have been priced at $5 per share, to increase the value received by the executive and thus its deduction.

Private companies

For private companies, the amount of executive compensation is often an issue.

“For C-corporations, the IRS will want to make sure the owners are not getting an excessive salary,” said Mark Plostock, tax manager for Israeloff, Trattner & Co., an accounting firm based in Garden City and New York. “However, with an S-corporation, the IRS will want to check that the executives are not taking too little out as salary. Sometimes, they will take out a relatively small salary and an excessive amount as dividends.” The IRS does not collect Medicare tax on dividends.

Plostock pointed to a famous example involving Sen. John Edwards, who, as owner of an S-corporation, had a salary that was a small fraction of the millions of dollars in dividends he earned. “Medicare tax is 2.9 percent, which is a lot of money when you’re talking about millions of dollars,” Plostock said.

To determine the amount of salary that is deemed reasonable, the IRS will examine the records of public companies in the same industry, Plostock said. Accounting firms also will look at comparable public companies’ records to advise their clients.

“What is considered a reasonable salary varies by industry,” he said.

Plostock added that it’s a good idea for companies to document the rationale for executives’ salaries.

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Business Financial Services

Accounting for the top earners