United States

IRS provides guidance on deduction of bonuses under all-events test

TAX ALERT  | 

In a recently issued Field Attorney Advice memorandum (FAA 20134301F), the IRS addressed the timing for deducting bonus liabilities under three different scenarios. The taxpayer in the FAA maintained three bonus plans under which employees were eligible to receive bonuses for services performed. The bonuses under each plan were paid in the year subsequent to the year in which the related services were performed, and each plan included terms that either (1) granted the taxpayer the ability to modify or rescind the payment of the bonuses, or (2) provided that the bonus amounts would be determined through a calculation that was based in part on subjective performance reviews conducted after the year in which the related services were provided. As described below, the IRS ruled that under each plan, the taxpayer's liability to pay the bonuses did not become fixed or determinable (and was therefore not deductible) until the year in which payment was made.

The FAA provides guidance to accrual-method taxpayers in determining when their bonus liabilities will meet the all-events test of section 461 and the regulations thereunder. The FAA should serve as a reminder to taxpayers that to the extent a bonus plan provides the taxpayer with the ability to rescind or modify its bonus liability prior to payment, it is possible the bonus liability will not be treated as fixed or determinable prior to payment. Taxpayers should consult with their tax advisors and take time to review their bonus plans to ensure bonus liabilities are being recognized in the proper tax period.

Background

Under the accrual method of accounting, a liability is generally recognized for federal income tax purposes in the taxable year in which: (1) all the events have occurred that establish the fact of the liability; (2) the amount of the liability can be determined with reasonable accuracy; and (3) economic performance has occurred with respect to the liability.1 Generally, all events have occurred that establish the fact of the liability when the event fixing the liability, whether that be the required performance or other event, occurs, or when payment is due, whichever happens earlier.2 Where a liability arises out of the provision of services to a taxpayer, economic performance occurs as the services are provided.3

With respect to bonus liabilities, terms providing for events that will occur prior to payment, but after the year in which the related services are performed, will often prevent the liability from meeting the all-events test of section 461 and the regulations thereunder. The determination of when a bonus liability is deductible by an accrual-method taxpayer thus relies heavily on the specific terms of the taxpayer's bonus plans.4

Discussion

As mentioned above, FAA 20134301F addresses the timing for deducting bonus liabilities under three different bonus plans maintained by the taxpayer. Under the first bonus plan, the taxpayer expressly retained a unilateral right to modify or eliminate the bonuses at any time prior to payment. The IRS determined that since this provision disavowed the taxpayer from any legal obligation to pay the bonuses (and the taxpayer was not otherwise obligated to pay the bonuses prior to payment), the taxpayer's liability did not become fixed or determinable until the year paid. Thus, the IRS ruled that the taxpayer could not deduct any bonus liabilities under the first plan until the taxable year of payment.

Under the second bonus plan, the taxpayer's board of directors (the Committee) met to approve the amount and payment of the bonuses during the first quarter of the year following the year the services giving rise to the bonuses were performed. The Committee had the right to modify or eliminate the bonus payments and, in prior years, did modify the bonus amounts. As with the first bonus plan, the IRS ruled that since the Committee had the ability to modify or rescind bonus payments (and had in the past modified such bonus payments), the liability did not become fixed or determinable until the bonuses were approved by the Committee. Thus, the IRS ruled the taxpayer could not deduct the bonus liabilities under the second plan until the taxable year in which the Committee approved the payment and amount of the bonuses (which coincided with the taxable year the bonuses were paid).

Finally, under the third bonus plan, the calculation of bonus amounts was based in part on subjective performance appraisals that occurred in the year subsequent to the year the related services were performed. Specifically, under this plan, the bonus amounts were based on a calculation that took into account various metrics, and although some of these metrics were fixed as of the end of the year the related services were performed, the calculation also took into account a performance score that was based on a subjective performance appraisal occurring in the subsequent year. The performance score resulting from the appraisal directly affected the calculation of the employee's bonus amount and could even result in no bonus being paid. In this scenario, since the subjective performance review directly impacted the bonus calculation, the IRS ruled that the bonus liabilities did not become fixed or determinable until the year in which the performance appraisals were conducted. Thus, the IRS ruled the taxpayer could not deduct the bonus liabilities under the third plan until the taxable year in which the performance appraisals occurred (which coincided with the taxable year the bonuses were paid).

Implications

Although unfavorable to the taxpayer at issue, this FAA provides additional guidance to accrual-method taxpayers in determining when their bonus liabilities will meet the all-events test of section 461 and the regulations thereunder. The FAA should serve as a reminder to taxpayers that to the extent a bonus plan provides the taxpayer with the ability to rescind or modify its bonus liability prior to payment, it is possible the bonus liability will not be treated as fixed or determinable prior to payment. Taxpayers should consult with their tax advisors and take time to review their bonus plans to ensure bonus accruals and deductions are being recorded in the proper tax period. Taxpayers that have established an improper method of accounting for deducting bonus liabilities may be able to file an automatic Form 3115 to request an accounting method change to a proper method of deducting bonus liabilities and to obtain audit protection for prior-year treatment.

1  See Reg. section 1.461-1(a)(2).

2  See Rev. Rul. 2007-3, 2007-1 CB 376, citing Rev. Rul. 80-230, 1980-2 CB 169.

3  Reg. section 1.461-4(d)(2)(i). Pursuant to Reg. section 1.461-4(d)(2)(iii), in the case of deferred compensation, the economic performance requirement will be deemed to be met to the extent that the amount is otherwise deductible under section 404.

4  For instance, both courts and the IRS have held in the past that various requirements, such as employment on the payout date or payment approval by the taxpayer's board of directors, will keep the liability from meeting the all-events test until the date payment or board approval occurs. However, in Rev. Rul. 2011-29, 2011-49 IRB 824, the IRS ruled that a bonus liability may meet the all-events test prior to the year the bonus is paid even where the plan requires the payee to be employed on the date of payout, as long as the plan provides that the forfeited bonus will revert to a pool to be reallocated among the remaining eligible employees. The IRS ruled that because any bonuses allocable to an employee who left his or her employment prior to the date the bonuses were paid was reallocated to remaining, eligible employees, the taxpayer had a fixed liability for the total bonus amount as of the end of the taxable year in which the related services were provided. The IRS stated that the liability became fixed in the service year regardless of the fact that the taxpayer did not know the identity of the ultimate recipients of the bonuses or the amount each individual employee would receive.

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