The old adage that the best defense is a good offense holds new meaning for companies facing the prospect of not one but two beefed-up Internal Revenue Service audits.
In the past year, the IRS has instituted redesigned, tougher audits of employee pension plans and executive compensation programs at Fortune 1,000 and other large companies, part of a drive to crank up enforcement and crack down on scofflaws. Already, the agency has identified dozens of companies violating tax code provisions on everything from pension plan vesting to golden parachutes, according to consultants familiar with the new audits.
In the area of pension plans alone, the IRS has assessed individual companies hundreds of millions of dollars in additional taxes after audits revealed miscalculations in pension benefits and related errors. The agency has also imposed tax penalties on underpayments at specific companies "in the six figures," according to one IRS senior program manager. The agency doesn’t name audited companies.
In light of the developments, advice from IRS agents and tax experts is straightforward: Don’t wait to get audited to act. Companies should scrutinize their pension and executive compensation plans and voluntarily make needed adjustments. In taking the offensive, they could save tremendous time and money by avoiding a much more intrusive government audit, industry experts say.
"It’s critical that key players in the organization realize this is coming down the pike. Sooner or later they need to get a better handle on it," says Monique Guesnon, a manager with PricewaterhouseCoopers’ human resources services in New York who’s helping at least five clients perform self-audits of executive pay programs in light of the stricter policies.
The IRS is doing its share to alert companies to the changes, sending officials on hundreds of speaking engagements a year and maintaining extensive Web pages to explain how the audits work and what resources and remedies are available.
"Pay attention to the operation of your plan," says Mark O’Donnell, an IRS customer education and outreach director for the new pension plan audit program. "Defects often arise because of neglect or not having the information. We want to minimize that."
Parsing pension plans
Of the revamped audits, the IRS’ pension plan exam, called the Employee Plans Team Audit Program, has the most far-reaching impact, and the biggest plans are the biggest targets, industry watchers say.
According to IRS estimates, 690,000 U.S. companies or corporate subsidiaries offer defined-benefit or defined-contribution pension plans, but the top 1 percent accounts for 60 percent of plan participants and 70 percent of total pension assets.
Historically, the IRS hadn’t targeted top pension providers for audits, and hadn’t kept up with cash balance and other recent changes in plan design. That changed in the late 1990s, when the agency restructured to become more efficient. As part of the revisions, the IRS revamped its pension audits, running a two-year pilot before integrating what was learned into the Employee Plan Team Audit Program exams, which began in late 2003. The focus of those audits: public and private companies running plans with more than 2,500 participants.
EPTA exams, as they are called, are structured to analyze a sort of "10 Most Wanted" list of pension plan trouble spots. Auditors comb through a company’s Form 5500 pension plan tax filing, looking for dramatic drops in vesting or distribution in a given year, changes in benefits when one company acquires another, how deferrals are treated and whether plan documentation matches operation, among other things.
The IRS posts its top 10 list on an EPTA Web site, so it’s a logical starting point for a company doing a self-audit, IRS officials and accounting consultants familiar with the audits say.
Chris Lipski, a partner with Ernst & Young’s human capital practice in Cleveland, is shepherding several companies through IRS pension audits--"very large companies you’ve heard of," he says, though he could not disclose names. Lipski suggests starting an internal review by forming an ad hoc committee headed by a human resources executive familiar with the company’s pension plan administration, working with finance and tax departments, the general counsel’s office, any contractor responsible for pension administration, plus outside attorneys and CPAs.
Have everyone meet at least once to orchestrate the review and divide responsibilities, Lipski says. The internal audit itself should include: gathering and reviewing pension plan documents, performing a test or sample to pinpoint weak spots, completing a more comprehensive check in those areas, taking any necessary steps to correct mistakes and documenting every stage of the review.
With Lipski’s clients, most mistakes have been inadvertent administrative errors, such as using the wrong definition of compensation to calculate pension amounts or mistakenly determining that someone isn’t vested so they don’t begin accruing benefits when they should.
To further shield themselves from an audit, companies can enroll in the EPTA’s Voluntary Correction Program, where they can formally disclose any errors they may have uncovered and pay a fee based on the number of plan participants. The IRS has 150 days to approve the company’s self-audit, during which time the agency is restricted from starting its own examination. About 2,300 companies have already signed up for the program, according to O’Donnell, the EPTA customer education and outreach director.
Lipski recommends that companies do a quick analysis, file a Voluntary Correction Program application, and then spend the time it takes the IRS to follow up with a more thorough review.
If a self-audit sounds like a lot, it’s nothing compared to the real deal. An EPTA audit can involve up to five agents, take up to 200 or more staff days and involve 75 to 150 separate requests for documents, according to agency officials. When they’re on site, agents need desks, phone lines, computer hookups and a company liaison to answer questions. Start to finish, the process could take up to two years, says Peter Breslin, the IRS’ EPTA senior program manager. The IRS initially undertook 40 EPTA exams, but eventually (when enough agents are trained) it will have about 90 of the exams under way at any given time, says Mark Hoffman, EPTA national coordinator.
Minding executive pay
The other revamped IRS audit targets salary and benefits paid to top officers at public and private companies with annual revenue of $10 million—fallout from scandals at companies such as Tyco International and WorldCom, where executives awarded themselves enormous pay packages.
In a yearlong pilot project started in October 2003 and involving two dozen unnamed companies, the IRS’ large and medium-sized business division zeroed in on seven areas of concern: nonqualified deferred compensation plans, stock-based compensation, fringe benefits, the $1 million cap on deductible compensation, golden parachutes, split-dollar insurance and family limited partnerships.
The agency investigated but dropped an eighth issue, employee leasing, as not being a significant problem among large and medium-sized businesses. The IRS is using results of the pilot program to craft guidelines that will be included in routine corporate tax audits, according to industry watchers.
What the IRS found in its initial executive-pay audits ranged from the astounding to the mundane, says Andrew Liazos, a Boston-based attorney at McDermott Will & Emery who has attended agency briefings on the topic. In the pilot, the IRS matched corporate returns against returns for individuals and found that some executives didn’t file tax returns at all, says Liazos, head of his firm’s executive compensation practice.
The IRS also uncovered instances where companies deducted deferred compensation from their balance sheets before it was paid, allowed executives to collect deferred compensation before agreed-upon dates without tax consequences, or changed targets for executives’ performance-based pay during a fiscal year without first receiving board or shareholder approval.
The tougher audits also found "a laundry list" of violations of fringe benefit tax laws, such as companies allowing execs to take out loans and never repay them or use corporate jets without declaring such use as income, Liazos says.
Many problems with executive compensation plans stem not from nefarious intentions but from poor oversight, Liazos says. "We worked with a company with a bonus plan that was supposed to be approved by shareholders every five years, but five years went by and nothing happened," he says.
As with pension plans, IRS officials and consultants recommend that companies do an internal review of their executive compensation program.
Consultants recommend having outside legal counsel or a CPA firm direct an executive pay plan compliance audit because of the complexity of such reviews. If a law firm leads the audit, the information gleaned would be protected by attorney-client confidentiality in the event of an IRS audit. The best course might be to have outside legal counsel hire the CPA, so any communication about a compliance review between the CPA and the company or the CPA and legal counsel would also be shielded, consultants say.
In all cases, it’s vital that key staff be aware of what’s happening, says PricewaterhouseCoopers’ Guesnon.
A lot of larger companies have outsourced administration of benefits, including executive compensation plans.
"But the executives have a fiduciary responsibility even if it is outsourced," Guesnon says.
Workforce Management, January 2005, p. 60-61 -- Subscribe Now!