In a field attorney advice memorandum (FAA 20134301F), the IRS
analyzed an employer's tax deduction timing related to bonuses
paid to employees. According to the facts of the memorandum, the
employer sponsors multiple bonus plans that pay cash awards to
employees.
To receive the bonuses, the employees must be employed on the last
day of the taxable year, but not on the bonus payment date. The
bonus payment date is after the end of the employer's taxable
year, but within 2½ months after the end of the taxable
year.
Under the accrual method of accounting, for an employer to receive
a tax deduction for bonuses in the year in which the bonuses are
earned rather than the year in which the bonuses are paid, the
bonuses must meet the "all events test" under Section 461
on the last day of the taxable year in which the bonuses are
earned. The all-events test is met when (1) all events have
occurred to establish the fact of the liability, (2) the amount of
the liability can be determined reasonably accurately, and (3)
economic performance has occurred.
The plans considered in the memorandum provide that the employer
retains the unilateral right to modify or eliminate the bonuses at
any time prior to payment. The IRS concluded that the bonus plans
did not meet the all-events test until the bonuses were paid to the
employees, because the fact and amount of the liability were not
established until that date. The IRS reasoned that because the
employer has the right to unilaterally eliminate or reduce the
bonuses at any time prior to payment, the employer is not legally
obligated to pay the bonuses. As a result, according to the
memorandum, the all-events test is not met at the end of the
taxable year.
In reaching this conclusion, the IRS considered multiple court
cases, but many of them were not tax related. Rather, the cases
focused on state law and an employer's legal obligation to
compensate employees when the employer retains the unilateral right
to not pay the compensation. The IRS's analysis concluded that
this type of unilateral right does not create a contract between
the employer and the employee, and even if a contract had been
created, there would be no breach of contract for failure to pay
the bonuses. As a result, the bonus plan does not fix the
employer's liability to pay the bonuses prior to payment of the
bonuses.
Some of the bonus plans addressed in the memorandum compute the
amount of the bonuses based on pre-established objective
performance criteria. The bonuses are not paid to the employees
until after the committee approves the bonus plan payment, which
occurs after the end of the taxable year, and the committee has the
ongoing right to adjust the bonuses before they are paid. The IRS
found that the committee's approval is more than a ministerial
act. Thus, according to the memorandum, the all-events test is not
met until the committee approves the bonuses and their payment,
because no bonus is paid without the committee's approval,
which is not automatic.
The formulas used to calculate the employees' bonuses are
driven by one or more metrics, some of which are fixed at year-end.
In some instances, the formula takes into account the
employee's individual performance appraisals, which are
conducted after the end of the year and therefore are not fixed at
year-end. The IRS concluded that when bonus amounts depend in whole
or in part on some subjective determination made after year-end
(e.g., a performance appraisal), the all-events test is not met at
year-end, because the subjective determination is one of the events
that fix the act and the amount of the liability.
The IRS determined that all of the bonus plan provisions and requirements discussed above result in the all-events test being met after the end of the employer's taxable year. Thus, the IRS concluded that the bonus deductions were not allowed until the taxable year in which the bonuses were paid.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
