For taxpayers using the cash basis accounting method, determining when to deduct accrued bonuses is typically a straightforward matter - the compensation deduction occurs when the bonus is paid.
Similarly, accrual basis taxpayers also believed that decision was simply determined by answering one question: was the amount earned by year-end and was it paid within 2½ months of year-end? If so, then the deduction was allowed in the year of accrual. If the employee later forfeited the bonus, it was considered a condition subsequent that did not prevent the deduction in the earlier year. Unfortunately, IRS, in recent guidance, has made clear that the necessary inquiry is far more granular. This guidance, discussed below, has forced many taxpayers to revise their bonus plans and file accounting method changes for back-year audit protection. Without a change to their bonus plans, taxpayers may suffer a significant deferral of their year-end bonus deductions.
The General Rule
The Internal Revenue Code (Sec. 461) allows accrual-basis taxpayers to deduct accrued bonuses (excluding related party transactions) if the following four conditions are met:
- All events must have occurred to establish the fact of the liability by year-end;
- The amount of the liability must be determinable with reasonable accuracy by year-end;
- Economic performance must occur by year-end; and
- Payment must be made within 2 ½ months of year-end.
Many companies have applied these provisions by treating forfeiture provisions that might cause an employee to forfeit the bonus as a condition subsequent that would not prevent the bonus from accruing at year-end. Others have simply focused on whether the bonus payments were made within 2 ½ months of year-end while ignoring the other three requirements.
In recent years, IRS has made clear in examinations that it considers the elimination of any risk of forfeiture of the bonus to be a condition precedent to establishing the fact of the liability. IRS has also made clear that taxpayers must satisfy each of the four requirements cited above, not just the requirement of payment within 2 ½ months. IRS has had a long-held position that a taxpayer must know the identity of the recipient of a bonus at year-end for that bonus to be deductible. Notwithstanding having lost on that position in court, IRS created uncertainty for taxpayers by publishing guidance announcing that it would not acquiesce in that decision. Even though IRS in recent years has not enforced this position, the outstanding published guidance has created uncertainty for taxpayers and the potential for unnecessary controversy during examinations.
Since most bonus plans require that the employee be employed by the company on the date the bonus is paid and permit eligible employees to be determined after year-end subject to a set formula, IRS’ position as stated above would defer the bonus deduction for most taxpayers until the date of payment.
IRS has issued two items of guidance that clarify its current position with respect to both of these issues. This guidance provides a roadmap for taxpayers to modify their bonus plans and secure a year-end bonus accrual.
Revenue Ruling 2011-29
In Rev. Rul. 2011-29, IRS considered a situation in which the terms of the employer’s bonus plan required that an aggregate minimum bonus amount be determined by year-end with the allocation to individual employees to be determined after year-end. The plan also provided that any bonus allocable to an employee who had left the company before the bonus had been paid would be reallocated to other eligible employees. On these facts, IRS concluded that the minimum bonus amount determined under the plan could be accrued at year-end if paid by the 15th day of the third month following year-end. This ruling reverses a previous ruling which reached a contrary conclusion, requiring that amounts to be paid to individual employees be determined by year-end.
IRS makes clear in the ruling that taxpayers must follow the accounting method change procedures in Rev. Proc. 2011-14 to change to the method described in Rev. Rul. 2011-29. Such filings provide taxpayers with back-year audit protection and a four year spread of any unfavorable catch-up adjustment that results from the method change. A favorable catch-up adjustment can be taken into account in full in the year of change. Companies that do not currently have a bonus plan with provisions similar to those in Rev. Rul. 2011-29 may modify their plans after filing the method change to secure back-year audit protection for the old plan.
While Rev. Rul. 2011-29 did much to increase the focus on the requirements and to provide some clarity on IRS’ position, some uncertainty still remained. More recent guidance at the end of last year provided guidance related to “pooled” bonus arrangements.
In November, 2012, IRS issued Chief Counsel Advice (CCA) 201246029 examining how Rev. Rul. 2011-29 would apply to a company that pays bonuses only to employees who are employed by the company at the time of payment. IRS considered a situation in which the company established a bonus pool to be paid out in the subsequent year. However, the company stipulated that employees must be employed at the time of the payment to be eligible. Further, the plan required that amounts not paid to an employee (because they were not employed at the time of payment) revert back to the company.
IRS determined that the company was not obligated to pay the bonus amount because the “fact of the liability” was not established until the payment date, as some portion may never be paid. Since the payment date came after year-end, IRS ruled that the company could not take a deduction for accrued bonuses until after year-end.
While the CCA is unfavorable for the taxpayer, it provides more clarity on how a bonus pool might be structured to secure a tax deduction. Specifically, the CCA identified that the critical element of the analysis was that the bonus amounts actually be paid to employees and not revert to the taxpayer. Therefore, elimination of the reversion of unpaid bonuses back to the company and reallocation of those bonuses to other employees would enable the bonus pool to qualify as a fixed obligation (if created prior to year-end).
Many companies feel very uncomfortable with the unjust and unintended benefit that might result from a provision that bonuses intended for one employee be paid to other employees. That said, those same companies know that turnover before bonuses are paid tends to be relatively low. As a consequence, it may be possible to authorize a minimum bonus pool before year-end in an amount that is reasonably expected to be paid to qualifying employees.
Taxpayers that are not properly accounting for their accrued bonuses under the guidance discussed above may have significant tax liability exposure that could result in financial statement disclosures. This exposure can be addressed by filing accounting method changes that provide back-year audit protection. Bonus plans may also be restructured to maximize the amount of qualifying year-end bonus accruals.
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.