James F. McDonough
Of Counsel
732-568-8360 jmcdonough@sh-law.comExamining the Audit Technique Guide
Author: James F. McDonough|November 6, 2015
The IRS’ Audit Technique Guide
Examining the Audit Technique Guide
The IRS’ Audit Technique Guide
The Internal Revenue Service prepares Audit Technique Guide (ATG) to address over 50 industries or topics for their examiners. The Non-Qualified Deferred Compensation Audit Technique Guide was designed to address common issues relevant to non-qualified plans. The ATG divides such plans into four groups: Salary Reduction Arrangements, Bonus Deferral Arrangements, Top-Hat Plans (aka Supplemental Executive Retirement Plans) and Excess Benefit Plans. There is an emphasis in the ATG on making certain that the deduction and the income recognition occur in the same year. What is more important is that the rules for recognizing income and FICA/FUTA are not the same.
What the Audit Technique Guide covers
The examiner is advised to look in several areas, including employment contracts, minutes of meetings of the Board of Directors, minutes of meetings compensation committee, employment contracts, insurance and annuity polices. These areas frequently yield items resulting in audit adjustments. Many of these arrangements have non-conforming elements, such as the ability to borrow against the fund or pledge it as collateral. Many times the fund is not available to creditors, thereby causing the individual taxpayer to be in to constructive receipt of what should be deferred compensation.
Income tax return Schedule M receives special attention. Schedule M items should be examined by the agent who is instructed to reconcile deferrals and payments. W-2s may reveal certain inconsistencies. Examiners are advised that excess Medicare wages represent deferrals of income while shortages represent current year distributions of deferred compensation. Often times the restrictions lapse without income recognition.
Why the Audit Technique Guide is needed
Consider a recent CCA which stated “[i]f at any time during a taxable year a nonqualified deferred compensation plan (I) fails to meet the requirements of section 409A(2), (3), and (4), or (II) is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in the service provider’s gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.” An executive was entitled to a retention bonus and the written plan allowed the company to accelerate the bonus. Such acceleration violated the time and form of payment rules. In year 3, months prior to vesting of the year 3 payment, the employer corrected the plan. The IRS held that the plan failed to meet the requirements of 409A at all times during year 3 and the correction prior to the vesting date did not cure the problem. The executive was treated as constructively receiving income in Year 3, with the IRS audit adjustment coming some two years later.
Finally, there are many limited liability companies that have deferred compensation plans that are not recognized as such. A service partner, such as a construction manager in a real estate development project who is vested in his partnership interest is not the same as an executive or IT manager with a partnership interest subject to a substantial risk of forfeiture.
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Examining the Audit Technique Guide
Author: James F. McDonough
The Internal Revenue Service prepares Audit Technique Guide (ATG) to address over 50 industries or topics for their examiners. The Non-Qualified Deferred Compensation Audit Technique Guide was designed to address common issues relevant to non-qualified plans. The ATG divides such plans into four groups: Salary Reduction Arrangements, Bonus Deferral Arrangements, Top-Hat Plans (aka Supplemental Executive Retirement Plans) and Excess Benefit Plans. There is an emphasis in the ATG on making certain that the deduction and the income recognition occur in the same year. What is more important is that the rules for recognizing income and FICA/FUTA are not the same.
What the Audit Technique Guide covers
The examiner is advised to look in several areas, including employment contracts, minutes of meetings of the Board of Directors, minutes of meetings compensation committee, employment contracts, insurance and annuity polices. These areas frequently yield items resulting in audit adjustments. Many of these arrangements have non-conforming elements, such as the ability to borrow against the fund or pledge it as collateral. Many times the fund is not available to creditors, thereby causing the individual taxpayer to be in to constructive receipt of what should be deferred compensation.
Income tax return Schedule M receives special attention. Schedule M items should be examined by the agent who is instructed to reconcile deferrals and payments. W-2s may reveal certain inconsistencies. Examiners are advised that excess Medicare wages represent deferrals of income while shortages represent current year distributions of deferred compensation. Often times the restrictions lapse without income recognition.
Why the Audit Technique Guide is needed
Consider a recent CCA which stated “[i]f at any time during a taxable year a nonqualified deferred compensation plan (I) fails to meet the requirements of section 409A(2), (3), and (4), or (II) is not operated in accordance with such requirements, all compensation deferred under the plan for the taxable year and all preceding taxable years shall be includible in the service provider’s gross income for the taxable year to the extent not subject to a substantial risk of forfeiture and not previously included in gross income.” An executive was entitled to a retention bonus and the written plan allowed the company to accelerate the bonus. Such acceleration violated the time and form of payment rules. In year 3, months prior to vesting of the year 3 payment, the employer corrected the plan. The IRS held that the plan failed to meet the requirements of 409A at all times during year 3 and the correction prior to the vesting date did not cure the problem. The executive was treated as constructively receiving income in Year 3, with the IRS audit adjustment coming some two years later.
Finally, there are many limited liability companies that have deferred compensation plans that are not recognized as such. A service partner, such as a construction manager in a real estate development project who is vested in his partnership interest is not the same as an executive or IT manager with a partnership interest subject to a substantial risk of forfeiture.
