ARTICLE
12 December 2012

Liability For Bonus Compensation Becomes Fixed When The Contingency Is Satisfied

In a recent legal memorandum (ILM 201246029), the IRS concluded that a liability for bonus compensation is taken into account in the year in which the bonuses are paid, because the taxpayer’s employees were required to still be employed on the date of payment in order to receive the bonus and ultimately some forfeited bonuses might revert to the taxpayer.
United States Tax

In a recent legal memorandum (ILM 201246029), the IRS concluded that a liability for bonus compensation is taken into account in the year in which the bonuses are paid, because the taxpayer's employees were required to still be employed on the date of payment in order to receive the bonus and ultimately some forfeited bonuses might revert to the taxpayer.

Under the taxpayer's incentive compensation plan (ICP), the aggregate amount of bonuses for book purposes was finalized at the end of the plan year based on the number of eligible employees employed on Dec. 31. Bonuses were determined during the annual compensation planning process in January or February. The aggregate amount of bonuses paid generally did not exceed the amount accrued for book purposes at the end of the year. The ICP required eligible employees to remain employed with the taxpayer when the bonuses were paid in order to receive a bonus.

In February, the taxpayer's compensation committee reviewed and approved the bonuses. The bonus accrual was put into an HR tool, and each of the taxpayer's section managers was allocated a total bonus amount for his or her employees. If any employee left before the manager allocated the bonus amount between the section employees, that employee forfeited the right to a bonus and the total bonus amount was allocated among the remaining employees. If the section manager finalized the individual bonus awards in the HR tool before an employee left, however, the forfeited bonus award was not allocated among the remaining employees; instead, the forfeited bonus award reverted to the taxpayer.

The taxpayer argued that the liability for bonus compensation was deductible in the year of service because the amount of bonuses actually forfeited represented a de minimis portion of the bonuses accrued at year end and paid by March 15. The taxpayer based its argument on Rev. Rul. 2011-29, 2011-2 C.B. 824.

In Rev. Rul. 2011-29, an accrual method taxpayer (X) established a bonus plan with a minimum total amount of bonuses payable through (i) a formula that was fixed prior to the end of the taxable year, or (ii) other corporate action made by the end of the taxable year, such as a resolution of X's board of directors or compensation committee. Under the program, employees needed to perform services during the taxable year and be employed on the date of the bonus payment. Any bonus amounts allocated to employees who were no longer employed on the payment date were reallocated to the other eligible employees. Thus, the aggregate amount of the bonus payment was not affected by the departure of any employee. The bonuses were paid after the end of the taxable year of the related services and before the 15th day of the third calendar month after the close of that year.

Based on these facts, the IRS stated that the fact of X's liability for the minimum amount of bonuses was established by the end of the year in which the services were rendered. Accordingly, the IRS determined that an employer can establish the "fact of the liability" under Section 461 for bonuses payable to a group of employees even though the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the taxable year.

In the ILM, the IRS concluded that the taxpayer's liability was not a fixed liability in the year of the related services. The IRS noted that once an individual's bonus award was set in the HR tool, it was not reallocated to the remaining employees if that employee left before the bonus was paid. Instead, such amounts reverted to the taxpayer. The IRS stated that the liability could become fixed only when the contingency — the employee's still being employed on the date of payment — was satisfied. The IRS also provided that there was no de minimis exception to this rule. Accordingly, the IRS concluded that the taxpayer's liability for bonus compensation is taken into account in the year in which the bonuses are 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.

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