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Taxpayers
generally prefer
to accelerate
deductions to
reduce their
current year
income and
taxes. In some
situations, the
tax code's
accounting rules
allow an
accrual-basis
employer to
deduct a
year-end
employee bonus
in the current
year, even
though the bonus
will not be paid
until the
following year.
A recent IRS
Chief Counsel
memorandum (FAA
20134301F)
highlights some
of the pitfalls
that can affect
when bonus
compensation is
deductible.
Accrual
Method
Under the
accrual-method
of accounting
(in contrast to
the cash-method
of accounting),
a liability is
incurred, and
can be deducted,
in the year in
which:
All the events
have occurred
that establish
the fact of the
liability;
The amount of
the liability
can be
determined with
reasonable
accuracy; and
Economic
performance has
occurred.
The first
factor, the
all-events test,
is met when the
event fixing the
liability occurs
and payment is
unconditionally
due. Although an
expense may be
deductible
before it is
payable,
liability must
be firmly
established. The
"fact of
liability"
depends on
whether legal
rights or
obligations
exist as of the
close of the
year, not the
probability that
the rights will
arise in the
future.
Bonus
Plans
An employer may
establish an
arrangement or
plan that will
pay a bonus to
its employees in
the succeeding
year, based on
an evaluation of
current year
performance.
Performance
could be
determined by
objective
factors, such as
numerical goals
set for the
company or the
employee. These
bonuses may be
deductible in
the earlier year
even though the
employee, who
must figure
taxes on the
cash method,
won't need to
recognize the
income until it
is paid. Or
performance may
be based on more
subjective
factors, such as
an individual
performance
appraisal or the
employer's
discretion.
These bonuses
may be
deductible in
the later year.
The requirements
for awarding the
bonus must be
scrutinized, to
determine when
the liability
becomes certain.
Is the
liability
deductible?
The IRS has
stated that a
bonus can be
deducted in the
current year if,
under a bonus
plan, the
employee is
notified in the
current year the
employee will
receive a bonus,
even though the
bonus is not
calculated or
paid until the
following year.
An employer's
bonus liability
that is
ascertainable by
a fixed
standard, such
as a percentage
of profits at
the close of the
year, accrues
and is
deductible in
the current year
even though the
computations are
not made until
the following
year.
A bonus is not
deductible prior
to payment if an
employee must
remain employed
until the time
of payment, and
if a forfeited
bonus reverts to
the employer.
However, even if
an employee must
be employed
until paid, the
IRS has ruled
that a bonus is
deductible under
a pooled
arrangement
providing that
any forfeited
bonuses are
reallocated to
the employees as
a group, where
the minimum
amount payable
to the group is
determinable
through a fixed
formula at the
end of the year
or by board
action before
the end of the
year.
Employers may be
denied a
deduction in the
current year if
there are
uncertainties or
conditions on
payment. As
stated above, a
condition that
the employee
must remain with
the company
until payment
prevents accrual
before the
payment. A
deduction is not
available if the
payment is
subject to
significant
contingencies
involving
corporate
affairs, such as
approval by the
board, or a
requirement that
the company
attain a
particular cash
position. If
there is no set
formula, and
bonuses will not
be determined
until after the
close of the
year, the
bonuses do not
accrue until the
later year.
In the IRS
memorandum,
Chief Counsel
determined that
a bonus could
not be accrued
in the earlier
year in the
following
situations:
The employer
retained the
right to
unilaterally
modify or
eliminate the
bonus plan or
the bonuses
themselves at
any time, in its
discretion. The
employer had no
legal obligation
to pay the bonus
until it was
actually paid.
The plan
requires a
committee of the
board of
directors to act
in the following
year to approve
the bonus
computation and
the payment of
bonuses. There
is no legal
obligation
because the
committee must
approve the
bonuses, and
that approval is
not automatic.
The bonus
depends not only
on objective
formulas but
also on the
employee's
individual
performance
score, based on
appraisals that
are not
performed until
after the end of
the year.
There is a
tension between
the employer's
desire to
accelerate the
deduction and
its desire to
retain maximum
control over the
payment of
bonuses. An
employer that
wants to deduct
the bonuses in
an earlier year
must be willing
to relinquish
some of its
discretion to
determine the
bonus.
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