If you're an owner/executive of a C corporation, it's time to sit down with your tax adviser to see if your compensation passes IRS muster.
Reason: Part of the IRS' rejuvenated audit effort (see story below) includes a new program to measure compliance and target abuses related to executive compensation. As a result, IRS auditors will pay more attention to compensation arrangements of business owners and top
The IRS is red-flagging the following five forms of compensation. That doesn't mean they're off-limits; it just means you should expect the IRS to examine them closely this year and in upcoming years. With that in mind, you may need to restructure the deal.
1. Nonqualified deferred compensation. In particular, the IRS will eyeball the timing of deductions for deferred amounts. The agency wants to make sure that the deduction has been postponed until the employee recognizes corresponding taxable income.
Also, the IRS will examine whether your company's deferred compensation arrangements trigger currently taxable income under the "constructive receipt or economic benefit" doctrine. Translation: If you effectively control the timing of the income or have a vested right to the funds, the IRS says you should pay taxes immediately.
A related issue: How has your company handled payroll taxes? They're due when the deferred compensation vests, not when you receive the money.
2. Split-dollar arrangements. The IRS wants to make sure that executives participating in these plans recognize the proper amount of taxable income each year.
4. Tax shelters. The IRS is also hot on the trail of certain transactions that have no purpose other than tax avoidance.
Example: The IRS will scrutinize a taxpayer's attempt to use professional corporations or other taxable entities to avoid
payroll and income taxes. In such deals, taxpayers take an accelerated current business expense deduction for de-ferred compensation through the use of an employee-leasing arrangement in an offshore tax haven.
Not only would this scheme be disregarded (and deductions denied until taxable compensation is recognized), but it's a "listed" transaction. Participants have to report their involvement on their federal tax return, which is likely to draw the IRS' attention.
5. Family limited partnerships. FLPs can be great vehicles for avoiding income and estate taxes while shifting family-business ownership to the next generation at a discounted value.
But don't make the common mistake of maintaining too much control over the partnership. That could prompt a court to invalidate your FLP, causing assets to be returned to your taxable estate (after your death) and taxed at their full value.
For an FLP to meet the new scrutiny, you should create it, and run it like a real partnership, not as your private piggy bank. (For more FLP advice, see 1/12/04 issue.)
Don't let up on tax planning
The IRS won't specifically inform you if you're included in its exec comp audit program. Instead, IRS examiners auditing a corporate return may ask to see corporate officers' Forms 1040 to review them for consistency with the corporate return. The audit's focus likely will be on the timing of the employer's deductions as well as the company's compliance with reporting and withholding obligations.
Bottom line: Now is an especially good time to avoid contrived strategies brought to you by tax-shelter promoters.
But that doesn't mean an end to tax planning. Always make the most of established, legal tactics, such as deferring earned income through a retirement plan. Defined-benefit plans and age-weighted profit-sharing plans are legitimate ways to skew the benefits in your favor if you're older than your employees.
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