United States: Accrued Bonus Deduction: Not Just a 2˝ Month Test

Last Updated: April 2 2013
Article by Luke Coombs

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 2˝ 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:

  1. All events must have occurred to establish the fact of the liability by year-end;
  2. The amount of the liability must be determinable with reasonable accuracy by year-end;
  3. Economic performance must occur by year-end; and
  4. Payment must be made within 2 ˝ 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 ˝ 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 ˝ 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.

CCA 201246029

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.

Conclusion

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.

To print this article, all you need is to be registered on Mondaq.com.

Click to Login as an existing user or Register so you can print this article.

Authors
 
In association with
Related Video
Up-coming Events Search
Tools
Print
Font Size:
Translation
Channels
Mondaq on Twitter
 
Register for Access and our Free Biweekly Alert for
This service is completely free. Access 250,000 archived articles from 100+ countries and get a personalised email twice a week covering developments (and yes, our lawyers like to think you’ve read our Disclaimer).
 
Email Address
Company Name
Password
Confirm Password
Position
Mondaq Topics -- Select your Interests
 Accounting
 Anti-trust
 Commercial
 Compliance
 Consumer
 Criminal
 Employment
 Energy
 Environment
 Family
 Finance
 Government
 Healthcare
 Immigration
 Insolvency
 Insurance
 International
 IP
 Law Performance
 Law Practice
 Litigation
 Media & IT
 Privacy
 Real Estate
 Strategy
 Tax
 Technology
 Transport
 Wealth Mgt
Regions
Africa
Asia
Asia Pacific
Australasia
Canada
Caribbean
Europe
European Union
Latin America
Middle East
U.K.
United States
Worldwide Updates
Check to state you have read and
agree to our Terms and Conditions

Terms & Conditions and Privacy Statement

Mondaq.com (the Website) is owned and managed by Mondaq Ltd and as a user you are granted a non-exclusive, revocable license to access the Website under its terms and conditions of use. Your use of the Website constitutes your agreement to the following terms and conditions of use. Mondaq Ltd may terminate your use of the Website if you are in breach of these terms and conditions or if Mondaq Ltd decides to terminate your license of use for whatever reason.

Use of www.mondaq.com

You may use the Website but are required to register as a user if you wish to read the full text of the content and articles available (the Content). You may not modify, publish, transmit, transfer or sell, reproduce, create derivative works from, distribute, perform, link, display, or in any way exploit any of the Content, in whole or in part, except as expressly permitted in these terms & conditions or with the prior written consent of Mondaq Ltd. You may not use electronic or other means to extract details or information about Mondaq.com’s content, users or contributors in order to offer them any services or products which compete directly or indirectly with Mondaq Ltd’s services and products.

Disclaimer

Mondaq Ltd and/or its respective suppliers make no representations about the suitability of the information contained in the documents and related graphics published on this server for any purpose. All such documents and related graphics are provided "as is" without warranty of any kind. Mondaq Ltd and/or its respective suppliers hereby disclaim all warranties and conditions with regard to this information, including all implied warranties and conditions of merchantability, fitness for a particular purpose, title and non-infringement. In no event shall Mondaq Ltd and/or its respective suppliers be liable for any special, indirect or consequential damages or any damages whatsoever resulting from loss of use, data or profits, whether in an action of contract, negligence or other tortious action, arising out of or in connection with the use or performance of information available from this server.

The documents and related graphics published on this server could include technical inaccuracies or typographical errors. Changes are periodically added to the information herein. Mondaq Ltd and/or its respective suppliers may make improvements and/or changes in the product(s) and/or the program(s) described herein at any time.

Registration

Mondaq Ltd requires you to register and provide information that personally identifies you, including what sort of information you are interested in, for three primary purposes:

  • To allow you to personalize the Mondaq websites you are visiting.
  • To enable features such as password reminder, newsletter alerts, email a colleague, and linking from Mondaq (and its affiliate sites) to your website.
  • To produce demographic feedback for our information providers who provide information free for your use.

Mondaq (and its affiliate sites) do not sell or provide your details to third parties other than information providers. The reason we provide our information providers with this information is so that they can measure the response their articles are receiving and provide you with information about their products and services.

If you do not want us to provide your name and email address you may opt out by clicking here .

If you do not wish to receive any future announcements of products and services offered by Mondaq by clicking here .

Information Collection and Use

We require site users to register with Mondaq (and its affiliate sites) to view the free information on the site. We also collect information from our users at several different points on the websites: this is so that we can customise the sites according to individual usage, provide 'session-aware' functionality, and ensure that content is acquired and developed appropriately. This gives us an overall picture of our user profiles, which in turn shows to our Editorial Contributors the type of person they are reaching by posting articles on Mondaq (and its affiliate sites) – meaning more free content for registered users.

We are only able to provide the material on the Mondaq (and its affiliate sites) site free to site visitors because we can pass on information about the pages that users are viewing and the personal information users provide to us (e.g. email addresses) to reputable contributing firms such as law firms who author those pages. We do not sell or rent information to anyone else other than the authors of those pages, who may change from time to time. Should you wish us not to disclose your details to any of these parties, please tick the box above or tick the box marked "Opt out of Registration Information Disclosure" on the Your Profile page. We and our author organisations may only contact you via email or other means if you allow us to do so. Users can opt out of contact when they register on the site, or send an email to unsubscribe@mondaq.com with “no disclosure” in the subject heading

Mondaq News Alerts

In order to receive Mondaq News Alerts, users have to complete a separate registration form. This is a personalised service where users choose regions and topics of interest and we send it only to those users who have requested it. Users can stop receiving these Alerts by going to the Mondaq News Alerts page and deselecting all interest areas. In the same way users can amend their personal preferences to add or remove subject areas.

Cookies

A cookie is a small text file written to a user’s hard drive that contains an identifying user number. The cookies do not contain any personal information about users. We use the cookie so users do not have to log in every time they use the service and the cookie will automatically expire if you do not visit the Mondaq website (or its affiliate sites) for 12 months. We also use the cookie to personalise a user's experience of the site (for example to show information specific to a user's region). As the Mondaq sites are fully personalised and cookies are essential to its core technology the site will function unpredictably with browsers that do not support cookies - or where cookies are disabled (in these circumstances we advise you to attempt to locate the information you require elsewhere on the web). However if you are concerned about the presence of a Mondaq cookie on your machine you can also choose to expire the cookie immediately (remove it) by selecting the 'Log Off' menu option as the last thing you do when you use the site.

Some of our business partners may use cookies on our site (for example, advertisers). However, we have no access to or control over these cookies and we are not aware of any at present that do so.

Log Files

We use IP addresses to analyse trends, administer the site, track movement, and gather broad demographic information for aggregate use. IP addresses are not linked to personally identifiable information.

Links

This web site contains links to other sites. Please be aware that Mondaq (or its affiliate sites) are not responsible for the privacy practices of such other sites. We encourage our users to be aware when they leave our site and to read the privacy statements of these third party sites. This privacy statement applies solely to information collected by this Web site.

Surveys & Contests

From time-to-time our site requests information from users via surveys or contests. Participation in these surveys or contests is completely voluntary and the user therefore has a choice whether or not to disclose any information requested. Information requested may include contact information (such as name and delivery address), and demographic information (such as postcode, age level). Contact information will be used to notify the winners and award prizes. Survey information will be used for purposes of monitoring or improving the functionality of the site.

Mail-A-Friend

If a user elects to use our referral service for informing a friend about our site, we ask them for the friend’s name and email address. Mondaq stores this information and may contact the friend to invite them to register with Mondaq, but they will not be contacted more than once. The friend may contact Mondaq to request the removal of this information from our database.

Security

This website takes every reasonable precaution to protect our users’ information. When users submit sensitive information via the website, your information is protected using firewalls and other security technology. If you have any questions about the security at our website, you can send an email to webmaster@mondaq.com.

Correcting/Updating Personal Information

If a user’s personally identifiable information changes (such as postcode), or if a user no longer desires our service, we will endeavour to provide a way to correct, update or remove that user’s personal data provided to us. This can usually be done at the “Your Profile” page or by sending an email to EditorialAdvisor@mondaq.com.

Notification of Changes

If we decide to change our Terms & Conditions or Privacy Policy, we will post those changes on our site so our users are always aware of what information we collect, how we use it, and under what circumstances, if any, we disclose it. If at any point we decide to use personally identifiable information in a manner different from that stated at the time it was collected, we will notify users by way of an email. Users will have a choice as to whether or not we use their information in this different manner. We will use information in accordance with the privacy policy under which the information was collected.

How to contact Mondaq

You can contact us with comments or queries at enquiries@mondaq.com.

If for some reason you believe Mondaq Ltd. has not adhered to these principles, please notify us by e-mail at problems@mondaq.com and we will use commercially reasonable efforts to determine and correct the problem promptly.