Another Accounting Standard Impact Benefit Plan Advisors(2)


Uncertain Tax Positions and Compensation

As if there isn’t enough change going on – revised SEC disclosures, potentially 400 pages of “final” 409A regulations, revised accounting standards for equity compensation, proposed legislation limiting the amounts of deferred compensation, ad nauseum. Benefit’s advisors must also deal with subtle and unexpected changes, like “FIN 48.”

Like many other recent accounting standards, this new requirement has developed in response to what many perceived as “abuses” in business tax and accounting practices. You may agree or disagree with that perspective, but the reporting position is now fact and you or your clients will have to deal with it.

Basically what this standard requires is that each entity subject to audit under generally accepted accounting principles assess their income tax position on all material items of income and expense. Any position taken on the tax return must generally satisfy a more likely than not standard of success. In assessing the likelihood of success, it is assumed that the applicable tax enforcement group is reviewing the position, has all the facts available and is familiar with the applicable law.

If a tax return position does not meet the more likely than not standard, the company must measure the potential impact on their tax liability and adjust their financial statements accordingly. There is also additional financial statement disclosures required relative to this standard.

This statement has very comprehensive impact. It applies to any entity that MAY owe a tax liability. That means it can apply to taxable entities, certain pass-through entities and tax-exempt entities (either because of unrelated business tax issues or the potential loss of tax-exempt status.) That means that this standard applies not just to employers, but also to their benefit plans. That is an important point because an issue may be immaterial to the employer, but significant to the plan.

The standard is currently effective for publicly traded companies and will apply to private enterprises for year beginning on or after December 15, 2006. However, the standard does effectively apply to positions taken on returns that are currently in process, as the liability assessment is based upon all open years, not just the current year. Also, in assessing any potential liability, the amounts of interest or penalties are also to be included.

This posting is not intended as a detailed analysis of the new standard. This is not the appropriate medium for that. Most accounting firms have been doing web based training on this standard and you can check those out to get detailed information. What I intend to cover over this week is various areas of compensation planning that can result in issues that must be reviewed for potential measurement under this standard. There are many, many areas related to compensation and benefits. Some of which are so familiar, that we may have forgotten that they do not reflect settled law where it is easy to get to a more likely than not standard. Also, this will help explain some of the calls you may be receiving from your clients.

Caveat:  My background is largely private companies. I am hoping that other members of the advisory board will chime in on public company concerns.

The Basics

  1. Reasonable compensation: The deduction under IRC Section 162 is limited to reasonable compensation for services. Amounts paid in excess of this reasonable limit are not deductible. How much work have you or your client done to get comfortable that the level of compensation being paid is reasonable at a more likely than not standard of success?
  2. Deduction for accrued bonuses: The temporary regulations under IRC Section 404, as well as the proposed regulations under IRC Section 409A, provide a haven from the classification of a payment as deferred compensation, if it is paid within 2 ½ months of the end of the tax reporting period. But, many employers take that as a safe harbor and fail to take other steps to demonstrate that the bonus was, in fact, accrued as of year-end. If reasonable, the risk associated with this matter may just be a timing different, but it still must be analyzed under FIN 48.
  3. Entertainment Expenses: IRC Section 274 sets some very rigorous and mechanical standards controlling the deductibility of travel and entertainment expenses. Amounts outside of these limits are not deductible. Frequently employer’s programs fail to capture this information and apply the appropriate limits on the tax return. There are also some soft issues in this area with respect to the allocation of costs, etc.

Tomorrow we will cover some of the executive compensation issues.