Accounting Methods & Periods

Accounting for Bonus Compensation Under the Final Corporate Estimated Tax Regs.

On August 7, 2007, Treasury issued final corporate estimated tax regulations under Sec. 6655, effective for tax years beginning after September 6, 2007 (TD 9347). These final regulations significantly modify the prior proposed regulations (REG-107722-00) and establish a comprehensive set of rules for corporations using the annualized income installment method. Although the annualization method is intended as a safe harbor for computing quarterly installments, in practice the new regulations leave some questions unanswered, casting uncertainty on how “safe” the safe harbor is. Ambiguities in the final regulations will require practitioners to work closely with their clients to develop supportable positions for estimated tax returns computed under the annualized income installment method. An example of this ambiguity is provided below in the context of accounting for bonus compensation deductions.

Special Rule: Reasonably Accurate Allocations

The final regulations contain several special rules that apply to specific deductions that Treasury and the IRS believed could result in significant distortions in the estimate of annualized taxable income. One of these special rules is provided in Regs. Sec. 1.6655-2(f)(2). This rule requires that specific items of deduction that are routinely incurred on an annual basis, or for which a special exception to general accounting rules exists, must be allocated throughout the tax year in a “reasonably accurate manner,” regardless of the annualization period paid or incurred or otherwise properly taken into account. The items of deduction identified for this special treatment are:

The regulations define “reasonably accurate manner” as “allocated ratablythroughout the taxable year.” Alternatively, a nonratable allocation will be considered to be made in a reasonably accurate manner if it provides a reasonably accurate estimate of taxable income for the tax year based on the facts known at the end of the annualization period. Regs. Sec. 1.6655-2(f)(2)(iii)(A) provides the following nonexclusive list of relevant factors to consider in evaluating allocations:

1. The extent to which the allocation is consistent with nontax books and records accounting for the item;

2. The extent to which the allocable portion of the item becomesfixed and determinableduring the applicable annualization period; and

3. The extent to which the allocation, if compared with a ratable allocation of the item, results in a better matching of the item to revenue, earnings, the use of property, or the provision of services occurring during the annualization period.

The regulations provide examples of nonratable allocations of bonus compensation that satisfy the relevant considerations. However, none of the examples addresses common scenarios involving bonus liabilities accrued for book purposes in a tax year preceding deductibility because either the all-events test is not met or the bonus compensation is paid later than 2½ months after the tax year of book accrual. In these cases, practitioners must evaluate the propriety of nonratable allocations for which few or none of the considerations enumerated in the regulations are relevant. The following examples illustrate the difficulty taxpayers may encounter supporting nonratable allocations when the current-year bonus deduction relates to book accruals in a prior tax year. 

Example 1—bonus accrual fixed by year end and paid within 2½ months:  XYZ Corp. is a calendar-year, accrual-basis taxpayer that uses the 3/3/6/9 annualization periods to compute its annualized income installments. XYZ has adopted a plan under which it pays an annual bonus to its employees equal to 2% of earnings. XYZ accrues for this amount and reports the liability each quarter in its nontax books and records. XYZ’s quarterly earnings throughout the 2008 tax year are $10 million, $6 million, $7 million, and $7 million, respectively. On December 31, 2008, XYZ declares a $600,000 bonus to its employees that is paid out on Jan-uary 15, 2009, and is properly deducted in XYZ’s 2008 tax year.

The special rule under Regs. Sec. 1.6655-2(f)(2) requires the bonus compensation deduction allowed for the tax year to be allocated in a reasonably accurate manner. XYZ could allocate the deduction ratably throughout the year, yielding a $150,000 deduction for the annualization period ended March 31, 2008. Alternatively, based on its earnings results and other information available as of March 31, 2008, XYZ could allocate $200,000 ($10 million × 2%) to the first quarter because the allocation represents a better matching of the bonus compensation to earnings in the quarter than a ratable accrual allocation and is consistent with the allocation provided in XYZ’s nontax books and records. 

Example 2—bonus plan that fails the all-events test in year of book accrual: Assume the same facts as Example 1, except that the plan contains additional terms that prevent the $600,000 accrued bonus from fixing prior to payment on January 15, 2009. Therefore, the $600,000 bonus payment is not deductible until the tax year ended December 31, 2009.

XYZ could allocate the deduction ratably throughout the year, yielding a $150,000 deduction for the annualization period ending March 31, 2009. Alternatively, XYZ may evaluate whether it can reasonably allocate the entire $600,000 bonus deduction to the annualization period ending March 31, 2009. This specific allocation would satisfy the second consideration provided in Regs. Sec. 1.6655-2(f)(2)(iii)(A): The item becomes fixed and determinable during the annualization period when payment is made. How-ever, the taxpayer must weigh other considerations as well, including the caution in Regs. Sec. 1.6655-2(f)(2)(iii)(B) that the “fact that a liability for an annual expense becomes fixed and determinable during an annualization period will not establish that allocating all of the expense to that annualization period has been done in a reasonably accurate manner if the facts known as of the end of the annualization period indicate otherwise.” 

Example 3—bonus plan deferring receipt of compensation (not paid within 2½ months):Assume the same facts as Example 1, except that the bonus is not paid until March 31, 2009. Because the payment is made more than 2½ months after year end, the plan defers the receipt of compensation, and the bonuses are not deductible until paid under Sec. 404.

Under these facts, none of the considerations enumerated in Regs. Sec. 1.6655-2(f)(2)(iii)(A) is relevant to the bonus compensation: (1) Given the inherent difference between generally accepted accounting principles (GAAP) and Sec. 404, the allocation of a Sec. 404 deduction throughout the year (ratable or otherwise) can never be consistent with GAAP; (2) the liability’s entire amount was fixed and determinable prior to any of the annualization periods in the current estimated tax year; and (3) the requisite services related to the liability occurred before (not during) any annualization period in the estimated tax year.

Because the list of considerations provided in the regulations is not exclusive, taxpayers may consider other factors to determine if a nonratable allocation provides a reasonably accurate estimate of taxable income. In the preamble to the regulations, Treasury and the Service acknowledge that various allocations may be considered to be done in a reasonably accurate manner and that taxpayers should have flexibility in determining which allocation to use, particularly when use of a specific allocation reduces administrative burdens. However, allocations that are made with the intent to distort will not be considered to have been made in a reasonably accurate manner.

Conclusion

The new estimated tax regulations made significant changes to the rules that most corporations have been following for over 23 years. The bonus compensation discussion above illustrates only one application of the new regulations to a specific item of deduction governed by a special rule. The regulations provide for several additional special rules as well as a revamped general rule, each differing to some degree from the rules taxpayers previously relied on. Therefore, corporations should modify their existing computation methodologies before their 2008 quarterly estimates become due (April 15, 2008, for calendar-year corporations).

From Gary L. Hecimovich, CPA, and Brian D. Fleming, CPA, Washington, DC

Mere Execution of Service or Insurance Contract Does Not Satisfy All-Events Test

Rev. Rul. 2007-3 holds that the mere execution of a service or insurance contract by an accrual method taxpayer/payor (TP) does not satisfy the all-events test for incurring a liability.

Example: A, a calendar-year, accrual-method TP, contracts with an accounting firm for 2006 tax return preparation services in December 2006. No tax services are provided to A in 2006, nor is payment due or made; instead, the tax services are provided in A’s 2007 tax year. According to Rev. Rul. 2007-3, the tax service expense is not deductible by A for its 2006 tax year.

An automatic change in accounting method to comply with Rev. Rul. 2007-3 is provided in Rev. Proc. 2007-14. The automatic change procedure applies to affected taxpayers that are not under examination or that are under examination and file within a window period (the 90-day or 120-day window). Rev. Proc. 2007-14 is effective for tax years ending on or after December 31, 2006.

Rev. Rul. 2007-3 potentially affects clients that are deducting (1) service expenses prior to performance or payment being made or due (which may be consistent with their financial statement reporting method) or (2) insurance expenses for the tax year of contract execution, where the tax year precedes the tax year of insurance coverage, premium payment, and premium payment due date.

All-Events Test for Service and Insurance Liabilities

Rev. Rul. 2007-3 provides that all the events have occurred that establish the fact of a liability for service and insurance liabilities upon the earlier of (1) the occurrence of the event fixing the liability, whether that be the required performance or other event, or (2) the date payment is due.

The ruling presents two factual situations, one involving the provision of services and the other the provision of insurance. As described in the revenue ruling, the TP, which uses the accrual method and employs a calendar tax year, enters into service and insurance agreements in December 2006. In both situations, payment of the expense is not due or made until January 2007, and, in both situations, contractual performance by the taxpayer’s payee does not occur until 2007. Performance with regard to the service agreement means the payee’s rendering of the services, and, with respect to insurance, it is insurance coverage. Thus, in both situations, the only event that has occurred in 2006 is the execution of the service and insurance contracts by the taxpayer.

Rev. Rul. 2007-3 concludes that, because the mere execution of a contract does not satisfy the all-events test, the service and insurance expenses have not been incurred and hence are not deductible for 2006. The revenue ruling adds that the all-events test for the service and insurance expenses is satisfied in 2007 upon the occurrence of the payment due date for the expenses, which in both situations precedes contractual performance by the payee.

Automatic Method Change for Service and Insurance Expenses

Accompanying Rev. Rul. 2007-3 is Rev. Proc. 2007-14, which provides procedures by which a taxpayer may obtain the consent of the Commissioner under Sec. 446(e) to automatically change its method of accounting for service and insurance expenses in order to comply with Rev. Rul. 2007-3. Rev. Proc. 2007-14 directs taxpayers to follow the terms, conditions, and procedures in Rev. Proc. 2002-9, set forth below:

1. Effective date for automatic change: Rev. Proc. 2007-14 is effective for tax years ending on or after December 31, 2006.

2. Sec. 481(a) adjustment: The Sec. 481(a) adjustment will be positive (increase in income). The Sec. 481(a) adjustment is computed as of the first day of the tax year of change and represents the difference on that date between what the taxpayer deducted under its present method and what it would have deducted if it had used the proposed method.

3. Sec. 481(a) adjustment period: The positive Sec. 481(a) adjustment will be taken into account ratably over four tax years beginning with the tax year of change.

4. Procedure for effectuating change: A Form 3115, Application for Change in Accounting Method, is completed and the original is attached to the timely filed return (including extensions) for the tax year of change. A copy of the Form 3115 must be filed with the IRS National Office no earlier than the first day of the tax year of change (the IRS address is provided in Section 6.02(6)(a) of Rev. Proc. 2002-9).

5. Audit protection: Once a copy of Form 3115 is filed, the IRS will be precluded from raising on examination an issue regarding the taxpayer’s use of the method being changed for a tax year prior to the tax year of change.

6. Taxpayer under examination or scheduled for examination: A taxpayer will be precluded from making the automatic change (or filing a manual change) if the taxpayer is currently under examination or scheduled for examination, unless the taxpayer qualifies to file under the 90-day or 120-day window periods described in Sections 6.03(2) and (3) of Rev. Proc. 2002-9. Filing the application per the “consent of director” provision (Section 6.03(4) of Rev. Proc. 2002-9) is not likely to be available, as the method to be changed would ordinarily be included as an item of adjustment in the year(s) under examination, and thus the director will not consent to the filing of the Form 3115.

7. Prior change (five-year rule): If the taxpayer, within the last five tax years (including the year of change), has changed, or applied to change, the same item of expense for which the taxpayer now desires to change under Rev. Proc. 2007-14, the taxpayer cannot make the change automatically and must file a manual application.

8. Designated automatic change number: The taxpayer must include on line 1a of the Form 3115 the designated automatic accounting method change number 106.

Change from Contract Execution Method

It should be noted that the automatic change from the “contract execution” method is not limited to clients that employ a present method by which nothing occurs, other than service or insurance agreement execution, during the tax year of deduction. This automatic change should also be made by clients that employ a present method by which the total cost (actual or estimated) of the service fee and/or the insurance expense is deducted for the tax year of contract execution and, for this same tax year, a portion of the fee and/or insurance premium is due or made or a divisible portion of the service and/or insurance coverage is provided. Under this situation, the positive Sec. 481(a) adjustment that results from the automatic change will be the difference between the total expense amount and the amount of the expense paid, due, or provided (assuming that the requirements of the recurring-item exception, where applicable, are satisfied).

Partial payment made or due: With respect to clients that use the “contract execution” method with an earlier event (i.e., performance, payment, or payment due) for a portion of the service and/or insurance expense amount also occurring in the tax year of contract execution, reducing the Sec. 481(a) adjustment by the partial payment or payment due amount is rather straightforward and without controversy. Similarly, partial performance of an insurance expense (i.e., insurance coverage) is divisible and easily determined. For example, if during the tax year of contract execution three months of insurance coverage is provided on a one-year insurance agreement with a total premium cost of $1 million, then the Sec. 481(a) adjustment amount of $1 million would be reduced by $250,000 (12× $1 million). Whether the Sec. 481(a) adjustment amount can be reduced by the cost of partial performance of a service expense for the tax year of contract execution depends on the rendered services’ being divisible.

Partial performance of a service expense—divisibility: Divisibility of a service expense allows the cost of the partial performance to be deducted for the tax year of partial performance. A service expense is divisible if payment of the cost of partial performance is not dependent (contingent) on the occurrence of a future event. For example, if the service contract provides that a progress payment or complete payment is due upon the service provider’s achieving a specified result (a benchmark, e.g., customer acceptance of work done so far, transported property delivered to destination, a blueprint, or a buyer found that consummates a property purchase), and the specified result does not occur in the tax year of partial performance, then the service expense is not divisible, and the cost of the partial performance is not deductible until the tax year the specified result occurs. On the other hand, if the service agreement does not condition a progress payment or full payment on the occurrence of a specified result, the cost of the partial performance is deductible for the tax year of partial performance. The exhibit above reflects the deductibility conclusions drawn with regard to the occurrence of an earlier event (i.e., performance or payment due or made) for a portion of the cost of the service and insurance expenses.

Recurring-item exception: Keep in mind that an expense item is de-ductible for the year “incurred.” An expense item is incurred when the all-events and economic performance requirements are satisfied. The deduc-tion conclusions reflected in the exhibit indicate (marked by the letter R) the use of the recurring-item exception for deduction in the tax year the all-events test is satisfied.

Under the recurring-item exception, an expense liability is treated as incurred for a tax year if: (1) at the end of the tax year, all events have occurred; (2) economic performance occurs on or before the earlier of the date the taxpayer files the return (including extensions) for the tax year all events occur or 8½ months after the close of that tax year; (3) the expense liability is recurring in nature; and (4) for the tax year the all-events test is satisfied, either the expense liability is not material or the deduction in this tax year results in a better matching of the expense liability against the income to which it relates.

With regard to service expenses, economic performance is satisfied for the tax year the services are provided. Thus, the recurring-item exception is applicable in the situation in which partial payment of the service expense is due or made in the earlier tax year. Economic performance for an insurance expense is satisfied for the tax year of expense payment. Hence, the recurring-item exception is applicable in the situation in which partial performance occurs (insurance coverage) or partial payment is due in the earlier tax year (under Regs. Sec. 1.461-5(b), the immaterial or better-matching requirement of the recurring-item exception is deemed to be satisfied for insurance expense but not service expenses).

From Rich Godshalk, J.D., Washington, DC

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