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Deducting accrued bonuses for tax seems like a simple exercise at first glance. Flux the bonus accrual to calculate the change in balance, apply the 2 ½ month rule, and you’re done. Easy, right? Yes, assuming the underlying facts of your company’s bonus plan meet the criteria for deductibility.
However, if you’ve never stopped to ask exactly what those facts are or are still unclear on the rules that allow for a deduction of accrued bonuses, it could be time to take another look. It’s possible your company may have deducted too much bonus expense in the past and may now have an unrecorded tax liability related to the improper method.
Alternatively, your company may be missing an opportunity to deduct more bonus expense if you’re not applying the 2 ½ month rule and are otherwise able to, based on the terms of the plan.
What are accrued bonuses and how do they work?
A bonus is a type of incentive compensation that an employer often promises to pay to an employee at a later time. The bonus is typically tied to an employee’s performance and may be paid out at the end of a predetermined period, like a quarter or a year.
Bonus compensation can take many forms, from cash bonuses to stock options, and can be an effective tool to motivate employees to work harder and achieve specific goals. For simplicity, this article will focus on a cash bonus plan, where the bonuses are paid to employees sometime after the company’s tax year-end.
How do you determine the tax deduction for a bonus accrual?
Step 1: Are the accrued bonuses “ordinary and necessary”?
The first expense defined in IRC Section 162 as an example of an ordinary and necessary business expense is compensation – more specifically, “a reasonable allowance for salaries or other compensation for personal services actually rendered.” Treas. Reg. Section 1.162-7(b)(3) provides further clarity on the “reasonableness” standard for compensation, stating, “reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances.” Assuming the bonuses meet this reasonableness standard, they will be deductible under IRC Section 162(a).
Step 2: Meeting the “all-events test”
Under IRC Section 461, for an accrual basis taxpayer to deduct the bonuses in the year of accrual, the following conditions must be met by year-end:
- Fixed: All events have occurred which determine the fact of the liability (that is, the taxpayer’s obligation to pay the bonus is “fixed”).
- Determinable: The amount of the liability can be determined with reasonable accuracy.
- Economic performance must have occurred.
Because it is uncommon for a company to be unable to determine the amount of its bonus accrual, let’s assume the second condition can be met without much trouble. The third condition is also fairly straightforward. In this case, economic performance occurs as the employee provides services to their employer (that is, does their job). Assuming this is a cash bonus plan that awards employees for prior performance and pays them at a later date, this prong is also met.
However, it is the first condition where many tax practitioners can be led astray. The company has a bonus plan, announces bonuses to their employees, and intends to pay them out at some date in the future. Surely the liability is fixed at this point, right? Not necessarily. A careful examination of the plan terms is required to determine whether any contingencies exist that could cause a bonus accrual to not be paid out.
For example, it is common for a bonus plan to include a clause stating that workers must still be employed with the company to receive their bonus, and leaving the company or being terminated prior to the payment date results in forfeited bonuses reverting back to the company. The IRS describes a similar fact pattern in Chief Counsel Advice Memorandum (CCA) 200949040, concluding that a liability arising from bonus compensation is deductible in the year the bonuses are paid (not accrued) if the taxpayer’s employees must still be employed to receive their bonuses. In other words, the fact of liability was not fixed in the year of accrual, failing the first prong of the all-events test.
Conversely, in Revenue Ruling 2011-29 the IRS describes a bonus plan in which forfeited bonuses were reallocated to other employees. In this case, because the bonus payments could not drop below a minimum amount, the IRS determined that the employer’s bonus obligation was fixed at year-end, thereby meeting the first condition of the all-events test.
Planning Tip: Examine your company’s bonus plan documents to determine whether any contingency provisions exist that might impact the deductibility of the accrual. If your company is not already claiming a deduction for amounts paid within 2 ½ months of year-end, an opportunity exists to accelerate the deduction depending on the facts of the plan. If your company is already claiming a deduction, but the facts of the plan do not support it, an accounting method change may need to be filed to avoid additional tax, interest, and penalties upon audit.
Step 3: The 2 ½ month rule
The bonus is deductible under IRC Section 162 and, upon examination of the plan, appears to meet the all-events test for deductibility in the year of accrual. So what’s the 2 ½ month rule all about?
Under IRC Section 404, compensation paid beyond the year in which it is accrued is generally assumed to be deferred compensation and therefore not deductible until the recipient includes the amount in income. Bonuses paid after the year in which they are accrued would fall under this general rule if not for the exception noted in Treas. Reg. Section 1.404(b)-1T A-2(b)(1). This exception effectively provides that compensation shall be considered part of a deferred compensation plan only if it is received after the 15th day of the third calendar month after the employer’s taxable year-end in which the services are rendered (the “2 ½ month rule”).
Simply put, if a company pays out its cash bonuses to employees within 2 ½ months of its tax year-end, the payments won’t be considered part of a deferred compensation plan for purposes of determining the timing of deductibility.
Planning Tip: A small change to bonus payment dates can mean the difference between getting a deduction now or waiting a full additional year to deduct the payments. Despite being considered a “temporary difference,” permanently moving up payment dates to fall into the 2 ½ month rule effectively accelerates the deduction forward a year every year in perpetuity (assuming the company continues to pay bonuses and the plan continues to meet the requirements for deductibility).
Step 4: Capitalization
As with many ordinary and necessary business expenses determined to be incurred during the taxable year, it’s important to at least consider whether the expenses may need to be capitalized under IRC Section 263 or similar provisions. For example, if the bonuses are paid to employees performing research and development, and otherwise meet all the criteria outlined above, the bonus expense may still be required to be capitalized under IRC Section 174.
Example tax deduction for bonus accrual
Workpapers are a critical part of supporting an accrued bonus deduction. A company that meets all the criteria for deductibility above might set up a workpaper calculation as follows.
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