To help its examiners, the IRS develops Audit Techniques Guides (ATGs) to provide insights into the issues and accounting methods that are unique to certain industries and types of compensation. While ATGs are designed to provide guidance for IRS employees, they can also reveal tax issues that need special attention from taxpayers, companies, and tax professionals.
In late August, the IRS released an updated version of its ATG for audits involving stock compensation: Equity (Stock) - Based Compensation Audit Techniques Guide, which seems to be a set of marching orders for IRS examiners. Companies, tax professionals, and compensation consultants will want to review it. (The update to the equity comp ATG follows a recent update to the IRS audit guide on nonqualified deferred compensation, issued in June.)
In this blog commentary, we provide an outline of the updated ATG on stock compensation. Parts of the guide summarize and confirm the tax treatment for different types of equity compensation. Other parts raise issues about how the IRS applies and interprets certain IRC sections and IRS regulations. Although we are still absorbing some of the guide, we are eager to publish this outline of it now to present its important points to the many people who follow myStockOptions.com and stock compensation developments.
How The IRS Prepares For Audits
During the initial examination process, a review of the company's SEC filings and the taxpayer's internal documents is a good place to start, recommends the ATG. The review of these documents may help to identify people who have received equity-based compensation, suggests the guide, which gives some tips for examiners (and anyone, really) on how to find the key provisions in SEC filings and company documents.
What IRS Looks For In Stock Transfers And Awards
The ATG lists, with brief explanations, the hot IRS topics that are leading to tax errors in recognizing income, withholding, reporting, and underpayments. Given all the other subjects related to stock compensation that the IRS could have selected, we assume that these are high priorities. In the guide, the IRS tells its auditors to determine whether:
- stock was actually transferred
- stock options were transferred to a related person
- the purchase price was reduced for a note used to acquire employer stock
- elections were punctually made under IRC §83(b) and records verify these timely elections
- a substantial risk of forfeiture exists to delay vesting according to the facts and circumstances
- dividends were paid on restricted stock
For each of these, the IRS explains the issues and then covers ways in which examiners can root out potential tax errors.
What IRS Looks For With Stock Options
In addition to the items listed above, the ATG delves into even greater detail with stock options. The guide tells IRS auditors to determine the type of stock options granted and to then closely examine whether:
- statutory stock options, which in IRS terminology includes ISOs and tax-qualified ESPPs, are following the specific IRC provisions for them, both in their grant terms and in the taxes incurred when shares are sold
- reporting and filing rules were complied with, including those for Form W-2 and those required for ISOs and ESPPs under IRC Section 6039
- appropriate amounts were promptly deposited for the withholding of FICA, FUTA, and federal income tax
The ATG also covers other types of equity-based compensation, instructing its examiners to look at the payout structure of phantom stock plans and of stock appreciation rights (SARs) at exercise. While the guide has information on restricted stock units (RSUs) near the end, this is merely a summary of the tax rules for them and a reminder that RSUs must follow IRC Sections 451 and 409A to avoid taxation at grant.