Editor: Kevin D. Anderson, CPA, J.D.
The IRS's issuance of several items of administrative guidance over the past few years indicates its increasing focus on the timing of an accrual-basis taxpayer's deduction of cash bonuses paid to its employees. Under the Sec. 461 deduction timing rules, bonus payments are properly deductible in the tax year in which all events have occurred to establish the fact of the employer's liability to pay the bonus and determine the amount of the bonus with reasonable accuracy. Furthermore, the company must in fact pay the bonuses within 2½ months after the end of the year to avoid the rules for nonqualified deferred compensation under Sec. 404(a)(5). Where an employer lacks an obligation at year end to pay a bonus, based on the terms of the bonus plan or the process by which it computes and approves the bonus, employers risk the IRS's disagreeing with the bonus deduction in the year earned and deferring the deduction to the year paid.
In Field Attorney Advice (FAA) 20134301F, the IRS concluded that an accrual-basis employer's bonus payments were not fixed and determinable at year end and therefore were not deductible until the year of payment. The taxpayer offered more than a dozen bonus plans under which employees could be awarded cash bonuses. Under the plans, employee bonuses were calculated based on formulas that were largely driven by the attainment of various metrics at the company, sector, unit, and/or individual employee level. Some of the plans took into account the employee's annual individual performance appraisals, which were finalized after year end but before the bonuses were paid. Other plans did not consider individual performance appraisals and were nonetheless calculated in a similar manner to the plans that took the appraisals into account, but the variable metrics—such as revenue, net operating profit, turn rate, etc.—were fixed as of the end of the year.
Under the facts, the taxpayer had the right under all of the bonus plans to modify or eliminate the bonuses at any time for any reason or for no reason at all. Bonuses awarded under the plans were generally not paid until after the committee of the board of directors approved the bonus plan settlement and the payment, both of which did not occur until after year end. All of the bonuses were paid after the end of the tax year but no later than the 15th day of the third month following year end. The plans also required that an employee be employed at the end of the tax year but not at the time the bonus was paid.
Based on the facts in the FAA, the IRS primarily concluded that the taxpayer's reservation of the right to unilaterally modify or eliminate the bonuses prevented the fact- and amount-of-the-liability prongs of the all-events test from being met any earlier than the date the bonuses were paid. Because of this unilateral right, in the IRS's view, the taxpayer had no legal obligation at year end to pay the bonuses.
The IRS pointed out that although there are cases in which the fact of the liability is satisfied absent legal liability, those cases involve some other event that fixes the taxpayer's liability. Because the taxpayer in the FAA explicitly disavowed any obligation to pay the bonuses, the IRS explained, neither the plans nor committee approval of the plans were events that fixed the liability. The IRS further determined that the taxpayer did not meet the amount-of-the-liability prong because the amount of the bonuses could not be determined with reasonable accuracy as long as the bonuses were subject to elimination or modification.
Additionally, the IRS concluded in the FAA that the all-events test was not met any earlier than the date the committee approved the bonuses so long as the bonuses were subject to committee approval. The committee's approval was more than a ministerial act, the IRS said, because the committee was required to approve both the bonus computation and the actual payment and therefore could change the manner in which the bonuses were calculated and the amount of bonuses that were ultimately paid. Finally, for those plans that used an employee's individual performance appraisal as a component of the bonus calculation, the IRS concluded that the all-events test was not met any earlier than the date the appraisal was completed because the appraisals were subjective as opposed to companywide objective metrics that were fixed at year end.
Before the FAA was issued, the IRS addressed aspects of the all-events test's application to year-end bonuses in Rev. Rul. 2011-29 and Chief Counsel Advice (CCA) 200949040. On facts vastly different from the FAA, Rev. Rul. 2011-29 held that an accrual-method taxpayer can meet the fact-of-the-liability prong for bonuses payable to a group of employees even though the taxpayer does not know the identity of the particular recipients or the amount payable to each until after the end of the tax year. In the revenue ruling, the total bonus payable was determined either through a formula that was fixed before year end or through other corporate action such as a board resolution made before year end, and bonus amounts that employees forfeited because they were no longer employed by the taxpayer on the payout date were reallocated to the pool.
In CCA 200949040, the IRS earlier concluded that the all-events test is not met at year end where the plan contains a provision requiring employees to be employed on the payout date to receive a bonus payment, and the plan contains no mechanism to revert any forfeited amounts back to the bonus pool. Although the FAA and CCA may not be used or cited as precedent, these memoranda provide valuable guidance and insight on how the IRS is likely to analyze a particular set of facts. Each of the above factors discussed in the FAA and CCA as precluding the all-events test from being met by year end, individually or collectively, raises the possibility that the IRS could conclude that the employer had no obligation at year end to pay the bonus and thus no fixed liability until the bonuses are actually paid.
Accrual-method taxpayers that currently deduct bonus payments without considering whether the all-events test has been met at year end can take certain steps to mitigate audit exposure. An analysis of a taxpayer's bonus plan(s) and what steps are taken to determine the bonus pool often reveals that the bonus payments deducted by the taxpayer in the year services are performed are not "fixed" at year end, even though they are paid within 2½ months of year end, and that, in the IRS's view, the taxpayer's current method is improper. In those cases, affected taxpayers should consider filing a Form 3115, Application for Change in Accounting Method, to change to a proper method and secure audit protection. To be even more cautious, taxpayers should consider altering their bonus plans to be closer to the facts of Rev. Rul. 2011-29.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Bethesda, Md.
For additional information about these items, contact Mr. Anderson at 301-634-0222 or email@example.com.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.