Deductions for Bonus Arrangements

Many annual bonus and long-term incentive plans provide for payments to participants within two-and-one-half months of the end of the employers tax year, so that the employer can deduct the payments in the prior tax year. Although payments must be made within this window to deduct the compensation expense in the earlier tax year, the plan also must meet certain other requirements.

General Rules

An accrual-basis taxpayer generally can deduct expenses if it has satisfied the all-events test. Sec. 461 and its regulations provide that the all-events test is met if all events have occurred that determine the fact of liability and the amount of such liability can be determined with reasonable accuracy. In addition, the all-events test for any item is met only if economic performance has occurred for the item.

Bonus Plans

Many employers sponsor annual bonus or incentive plans under which eligibility or an award is based on certain annual measures (such as sales, productivity and personal performance ratings). In determining when awards are deductible, both the plans terms and the payments timing are critical.

For plans that pay awards within two-and-one-half months of the employers year-end, the plan terms determine whether the employer can deduct the awards for the year just ended or in the payment year. To satisfy economic performance and the all-events test, the award amounts and the obligation to pay must be fixed by year-end.

First, the bonus amounts must be fixed as of year-end. An example is a bonus under a plan based entirely on financial data (e.g., return on assets or sales growth). This plan should meet this requirement, because the information needed for calculating the bonus is available at year-end, even if the numbers still need to be audited.

Second, participants rights to the bonuses must be vested (i.e., the companys obligation to pay the bonuses must be fixed) as of year-end. This requirement can be met in two ways. An individual participants right to a bonus may be vested at year-end. In this case, even if the individual quit the following year (but before the bonus was paid), he or she would still be entitled to it. Conversely, an employer can set up a fixed-dollar bonus pool and provide that the pool will be allocated among and paid to employees who satisfy the plans terms as of the payment date. If the employer is obligated to pay out the bonus pool, even if there is only one employee who ultimately meets the requirements, the all-events test should be satisfied.

Is It Deferred Compensation?

Amounts that are paid beyond two-and-one-half months of the end of the tax year are generally presumed to be deferred compensation. Under Sec. 404(a)(5), contributions to a nonqualified deferred compensation plan are deductible in the tax year the contribution is includible in the gross income of the employees participating in the plan. If more than one employee participates, separate accounts must be maintained for each employee. Under these rules, the deduction is allowed in the year the employee recognizes the compensation income (i.e., the payment year).

From Susan Lennon, J.D., Washington, DC