The Advisors' Blog

Earlier this summer, the Internal Revenue Service updated its “Equity-Based Compensation Audit Technique Guide.” It’s the first time the Guide has been updated since 2015 – and as Bruce Brumberg notes in this Forbes article, the new version came as a bit of a surprise.

The Guide isn’t an official pronouncement of the law. But it does provide a window into how the IRS uses SEC filings and other documents to examine whether equity compensation has been properly reported, subjected to withholding and recognized as income. Here’s an excerpt that illustrates the IRS’s expansive approach to examining compensation disclosures – and its willingness to expand an audit beyond the initial target, based on its findings:

Pertinent documents for compensation purposes filed with the SEC include Form 10-K (Annual Report), DEF 14A (Definitive Proxy Statement), and Form 4 (Statement of Changes in Beneficial Ownership). The individuals identified in the SEC reports are considered executives and directors under Security Exchange Act section 16(b).

Once the section 16(b) executives and directors with equity-based compensation arrangements have been identified, confirmation should be made on whether all compensation related to various compensation plans have been reported to the recipient (on the individual’s Form W-2 or Form 1099-MISC) and that the appropriate employment taxes have been withheld and paid. If the compensation awarded to the section 16(b) executives has not been properly recognized, the audit scope may need to be expanded to other executives, directors, and employees accordingly.

Bruce’s article highlights some of the issues that the Guide instructs IRS examiners to focus on:

– Loans to exercise options to ensure that they are recourse loans (i.e. you personally pay should you default) and whether they were forgiven/canceled or reduced.

– Qualifying and disqualifying dispositions for incentive stock options (ISOs) and tax-qualified ESPPs. These are shares from ISO exercises or ESPP purchases that were sold either before or after the statutory holding periods of two years from grant and one year from exercise/purchase that provide the best tax treatment.

– Annual limits on the size of ISO grants (only $100,000 can be vesting/first exercisable in one year) and ESPP purchases ($25,000 annual limit). While your company probably has a stock plan administration program to help it adhere to these limits (which are not adjusted for inflation), company mistakes can change your tax treatment by turning your ISO grant and ESPP into nonqualified stock options.

– Restrictions on transferred stock that create a substantial risk of forfeiture (SRF) which needs to lapse before taxes apply. The SRF concept is standard, for example, with most grants of restricted stock or RSUs, which must vest before you recognize taxable income and could be forfeited if you were to leave the company before the vesting date. A stock buyback right for your company at job termination is not seen by the audit guide as an SRF that postpones income recognition, as it defines those as “non-lapse restrictions.”

– Transfer of stock options to related persons, which makes them a “listed transaction” and could be an abusive tax shelter.

– Company reporting requirements for your ISO exercises (on Form 3921) and ESPP purchases (on Form 3922).

– Form W-2 reporting, including special reporting and codes for nonqualified stock options and other grants.

– Appropriate amounts and timely deposits of withholding for federal income tax, FICA (Social Security and Medicare), and FUTA.

– Timely IRC Section 83(b) elections for the early-exercise stock options used by private companies. Also for startups, whether any elections were made under IRC Section 83(i) to defer income.

If you are looking for something to keep you up at night, the Guide goes into a fair amount of detail on how examiners can use public disclosures to gather information and flag discrepancies.

– Liz Dunshee