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How bonus arrangements affect deduction timing

RFP
Employers often spend a lot of time designing a bonus plan to help attract, retain and motivate employees. But they should also consider how bonus arrangements affect their year-end income tax obligations.

Most employers want to deduct bonuses in the year they’re earned rather than the year they’re paid. They may believe that as long as they pay the bonuses within 2½ months after the end of the tax year in which the bonuses are earned, the bonuses are deductible in the year they’re earned rather than the year they’re paid. But that isn’t always true. The timing of bonus deductibility depends on many factors, including the method of accounting.

Employers may believe that as long as they pay bonuses within 2½ months after the end of the tax year in which the bonuses are earned, the bonuses are deductible in the year they’re earned rather than the year they’re paid. But that isn’t always true.ABC Co. uses the accrual accounting method and is a calendar-year taxpayer. Tom, one of the company’s top-performing employees, received a bonus within 2½ months after the end of ABC’s tax year in which he earned the bonus. This means that ABC’s tax deduction is governed by Section 461 of the Internal Revenue Code, and the company avoids the Section 404 deduction timing rules that apply to deferred compensation, which may cause the deduction to be deferred until the year the bonus is paid.

If ABC used the cash accounting method, deduction timing would be simple. Treas. Reg. Sec. 1.461-1(a)(1) allows the deduction in the year the bonus is paid.

The Section 461 rules are much more complex for an accrual-method taxpayer. Treas. Reg. Sec. 1.461-1(a)(2) provides that, under the accrual accounting method, a liability like an accrued bonus is incurred and generally deductible in the tax year in which:
  1. All events have occurred to establish the fact of the liability
  2. The amount of the liability can be determined with reasonable accuracy
  3. Economic performance has occurred for the liability
The first two prongs are referred to as the all-events test; the third prong is satisfied when the employee performs the bonus-related services.

All-events test
In applying the all-events test, it’s important to look at when the fact of a liability is established. In Rev. Rul. 79-410, the IRS addressed how the all-events test applies to a noncompensation accrued liability. The agency stated that “all events have occurred that determine the fact of the liability when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment therefore is due, whichever happens earliest.”

Consider how this would apply if a separate bonus plan was in place for each employee, including Tom. Suppose that to receive the bonus payment, Tom was required to be employed only on the last day of the tax year rather than on the bonus payment date. The amount of Tom’s bonus is determined based on an objective formula established before the end of the tax year that factors in ABC’s year-end financial data. Generally, the fact of the liability is established on Dec. 31, 2014, and the amount of the liability can be determined at that time. However, other provisions of the bonus plan may cause the fact of the liability to be established in 2015, when the bonus is paid.

Alternatively, suppose the facts are the same as described previously, but to receive the bonus, Tom is required to be employed on the bonus payment date. If he leaves before then, ABC retains the bonus. In this case, the event fixing the liability for the bonus is the payment date. Thus, all events occur to establish the fact of the liability on the bonus payment date in 2015, resulting in a deduction for the bonus in 2015.

Other factors may cause the fact of the liability to be established and the amount of the liability to be able to be reasonably determined in 2014, even if the employee is required to be employed on the bonus payment date to receive the bonus. This typically occurs when the accrued bonus is related to a group of employees instead of a single employee.

For example, an employer may use a bonus pool, with allocations to employees. The amount in the pool is determined either (1) through a formula that is fixed before the end of the tax year, taking into account financial data reflecting results as of the end of the tax year, or (2) through some other binding corporate action that specifies the pool amount, such as a board resolution made before the end of the tax year.

Let’s say that ABC has a bonus pool, and to receive the bonus, the employees must be employed on the bonus payment date. If Tom forfeits the bonus because he is no longer employed on that date, his bonus will be reallocated to employees who are still with the company. So, ABC will pay the entire amount of the bonus accrual to employees. In this case, ABC’s bonus liability is fixed at the end of the tax year because the company will pay the aggregate amount of the bonuses. Also, the amount of the bonus liability can be reasonably determined on Dec. 31, 2014, because the amount is established through a formula or board resolution in place on that date.

The company may also use a minimum bonus strategy, which includes a bonus pool but allows the employer to retain a specified amount of forfeited bonuses. Before year-end, ABC establishes an aggregate amount of bonuses that will be paid to the group of employees. It also analyzes forfeited bonuses in prior years to determine and set a minimum amount of the aggregate bonus pool that ABC will pay to employees.

Let’s say that over the past five years, an average 6% of bonuses have been forfeited by employees. ABC conservatively estimates that employees will forfeit no more than 10% of the aggregate bonuses and, before the end of the tax year, mandates that it will pay at least 90% of the aggregate bonus amount to employees. To the extent that the bonuses actually paid to employees are less than 90% of the aggregate bonus amount, ABC will pay additional bonuses to reach the 90% threshold.

The IRS considered this minimum bonus strategy in Rev. Rul. 2011-29 to determine whether the fact of the bonus accrual liability is established at year-end. The IRS recognized that, under the bonus plan, the employer is obligated to pay the group of employees the minimum amount of the bonuses determined by year-end. Applying this to ABC’s bonus, the liability is established at year-end for 90% of the aggregate bonus pool. The fact of the liability for any bonuses paid in excess of the 90% minimum amount is not established until those bonuses are paid. Rev. Rul. 2011-29 didn’t address the second prong of the all-events test, but clearly the amount was determined on the last day of the tax year because of the fixed formula or board resolution. Thus, assuming economic performance occurred on Dec. 31, 2014, under Rev. Rul. 2011-29, ABC may deduct the 90% minimum bonus amount in 2014 and deduct any amount paid in excess of the minimum amount in 2015.

Traps for the unwary
In a recently released IRS field attorney memorandum (Field Attorney Advice 20134301F), the IRS analyzed when an employer could take a tax deduction for bonuses paid to employees. The employer in this memorandum sponsored multiple bonus plans that paid cash awards to employees. To receive the bonuses, the employees had to be employed on the last day of the tax year, but not on the bonus payment date. The bonus was paid after the end of the employer’s tax year, but within 2½ months after the end of the tax year. The scenario described previously considered the situation where Tom was required to be employed on the last day of the tax year, but not on the bonus payment date. So, the all-events test was met on the last day of the tax year. In the field attorney memorandum, however, the IRS pointed out factors that caused the bonus liability not to meet the all-events test at the end of the tax year.

The bonus plans in the memorandum gave the employer the unilateral right to modify or eliminate the bonuses at any time before payment. The IRS concluded that the bonus plans didn’t 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. Because the employer could unilaterally eliminate or reduce the bonuses at any time before payment, the employer wasn’t legally obligated to pay the bonuses. As a result, according to the memorandum, the all-events test wasn’t met at the end of the tax year.

The memorandum addressed some bonus plans that compute the amount of the bonuses using pre-established objective performance criteria. The employer did not pay the bonuses to the employees until after a committee of the employer’s board of directors approved the bonus plan payment, which occurred after the end of the tax year. The committee had the ongoing right to adjust the bonuses before they were paid. Because the all-events test was not met until the committee approved the bonuses and their payment, and because no bonus was paid without committee approval and approval was not automatic, the employer did not meet the all-events test as of the end of the tax year, according to the memorandum.

The formulas used to calculate the employees’ bonuses in the memorandum were driven by one or more metrics, some of which were not fixed at year-end. In some cases, the formula factored in the employee’s individual performance appraisals, which were conducted after year-end and therefore were 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, the all-events test is not met at year-end, because the subjective determination is an event that fixes the fact and amount of the liability.

What to keep in mind
Determining the deduction timing of accrued bonuses is not as simple as it seems. Merely paying the bonus within 2½ months after the end of the tax year won’t always result in a deduction in the bonus performance year. Employers and tax return preparers should pay close attention to the provisions and operations of the bonus plan before reaching a conclusion on deduction timing.

Contacts
Jeffrey A. Martin
202.521.1526
jeffrey.martin@us.gt.com

G. Edgar Adkins Jr.
202.521.1565
eddie.adkins@us.gt.com

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