Accelerating FICA and FUTA Tax Deductions for Vacation and Bonus Pay

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

Editor: Jeff Kummer, MBA

Rev. Rul. 2007-12 holds that if the all-events test and recurring-item exception of Sec. 461 are otherwise met, an accrual-method taxpayer may deduct FICA and FUTA tax expenses (payroll taxes) in the year that the deferred compensation to which they relate is earned, regardless of whether that deferred compensation is deductible in a later year under Sec. 404. Unfortunately, it does not address the issue of when the all-events test is satisfied with respect to payroll taxes on deferred compensation. This item discusses questions about the application of the all-events tests to payroll taxes on two of the most common forms of deferred compensation: vacation pay and bonuses.

Rev. Rul 2007-12

The revenue ruling presents the following fact pattern:

  1. X, a calendar-year, accrual-method corporation, has a fixed liability to pay compensation for services provided by its employees at the end of year 1, which is deductible under Sec. 404 in year 2;
  2. As of the end of year 1, all events have occurred to establish X’s liability to pay the payroll taxes related to the compensation, and the amount of the liability can be determined with reasonable accuracy; and
  3. X has properly adopted the recurring-item exception under Sec. 461 for payroll taxes and pays the payroll taxes before the earlier of 8½ months after the end of year 1 or the date X files its income tax return for year 1.

The question presented is whether in this situation the payroll taxes on the deferred compensation can be deducted in year 1 if, under Sec. 404, the underlying compensation is not deductible until year 2. The ruling states that, while the compensation underlying the payroll taxes is subject to Sec. 404, because the payroll taxes themselves are not compensation, they are not subject to Sec. 404. Accordingly, they are subject to the accrual rules under Sec. 461, under which an expense is accrued in the year the all-events test is met (and the requirements for the recurring-item exception are met, if applicable). In this case, because all the requirements of the test and the exception are met for the payroll taxes in year 1, they are deductible in that year, even though the compensation is not deductible until year 2 under Sec. 404.

What Rev. Rul. 2007-12 Does Not Say

Rev. Rul. 2007-12 concludes that under certain circumstances payroll taxes attributable to deferred compensation expenses, which include vacation and bonus pay, may be deductible for a tax year that is earlier than the tax year in which the deferred compensation is deductible. Unfortunately, Rev. Rul. 2007-12 sets forth these certain circumstances in a conclusory fashion, providing no fact patterns or accompanying analysis as to when these conclusions are appropriate. With respect to vacation or bonus pay, in some common situations it is uncertain whether a taxpayer will meet the all-events test for payroll taxes on deferred compensation in the year that compensation is earned.

Satisfaction of the All-Events Test

Underlying compensation: Specifically, the revenue ruling does not address whether certain “termination of pay” provisions that are common to vacation and bonus pay plans render the all-events test unsatisfied at the end of the employer’s tax year in which the employees “earn” the vacation and bonus pay through their provision of services. Deduction of the payroll taxes for the tax year in which the employees earn the vacation and bonus pay through their provision of services is dependent, in part, on the employer-taxpayer’s satisfaction of the all-events test for its vacation and bonus pay liabilities at this tax year end.

The common “termination of pay” provisions referred to above include:

  1. Vacation pay expense—“use-or-lose” provision. A common feature of most vacation pay expense plans is that an employee must use the vacation pay by the end of the vacation pay plan year that follows the vacation pay plan year in which the employee earned the vacation pay, e.g., vacation pay earned in calendar year 2006 must be used by the end of calendar year 2007. If the employee does not use such earned vacation pay by the end of the following year, and the employee retains employee status on that date, the employee forfeits the vacation pay. Generally, employees are paid their earned vacation pay on voluntary termination of employment and on involuntary termination other than for cause.
  2. Bonus pay expense—“employment on payment date” provision. Typically, bonus pay expense plans provide that an employee who has otherwise earned the bonus pay will forfeit such compensation if the employee on the date the bonus pay is payable is no longer an employee. The loss of employee status would be attributable to an involuntary or a voluntary employment termination, retirement, or death. In most instances, the employer pays the employee bonus expenses within 2½ months after the end of the employer’s tax year in which the employee earned the bonus pay through the employee’s provision of services.

Payroll taxes: The second area in which Rev. Rul. 2007-12 provides neither analysis nor guidance is the satisfaction of the all-events test for the payroll taxes on vacation and bonus pay expense in light of the “payment is certain” standard set forth in Eastman Kodak, 534 F2d 252 (Ct. Cl. 1976), acq. 1996-2 CB 1. Eastman Kodak held that payroll taxes on earned but unpaid wages were deductible under the all-events test for the tax year in which the wages were earned because the obligation to pay the taxes was established as an automatic consequence of the definite obligation to pay the earned wages. Eastman Kodak also addressed when the payroll taxes on vacation and bonus pay expenses were deductible. Although the obligation to pay the vacation and bonus pay expenses in Eastman Kodak was just as certain as the taxpayer’s obligation to pay the earned wages, the court held that the taxpayer’s obligation to pay the payroll taxes on the vacation and bonus pay was not certain; thus, the all-events test was not satisfied for the payroll taxes on the vacation and bonus pay for the tax year in which the compensation was earned.

The obligation to pay the payroll taxes on vacation and bonus pay was not certain as of the last day of the taxpayer’s tax year in which the employees earned the compensation, the court in Eastman Kodak reasoned, because of the yearly FICA and FUTA wage ceilings. If an employee was over the payroll tax wage ceilings on the date the vacation and bonus pay was paid, the employer would not have any payroll tax liability. Because the payroll tax wage ceilings were so low in 1964 (the tax year at issue)—i.e., the FICA ceiling was $4,800 and the FUTA ceiling was $3,000—the court in Eastman Kodak was of the opinion that on an individual employee basis there was a real possibility that the tax would not be paid. (Such wage ceilings for earned but unpaid wages were not a factor in Eastman Kodak because the earned wages were paid in the first week of the following calendar year; thus, there was no real possibility that the ceilings would be exceeded.) The FICA tax wage ceilings for calendar years 2007 and 2008 are $97,500 and $102,000, respectively (Notices 2006-102 and 2007-92). The Medicare rate (1.45%) within the FICA tax has no wage ceiling. The FUTA tax wage ceiling for calendar years 2007 and 2008 is $7,000.

Because Rev. Rul. 2007-12 provides no analysis of the satisfaction of the all-events test for the deduction of the payroll taxes on vacation and bonus pay expense, but merely stipulates that “if” the all-events test is satisfied, it is not clear how the IRS will apply the “payment is certain” criteria in Eastman Kodak to current payroll tax wage ceilings. Rev. Rul. 2007-12 revoked Rev. Rul. 69-587, which held that payroll taxes on vacation and bonus pay expenses are not deductible until the tax year the underlying compensation is paid. In light of this, the IRS will presumably allow the deduction of the payroll taxes on vacation and bonus pay expense under certain circumstances for the tax year in which the underlying compensation is earned.

Deduction of Vacation and Bonus Pay Expense

Rev. Rul. 2007-12 indicates that a prerequisite for the deduction of the payroll taxes on the vacation and bonus pay expense for the tax year the employees “earn” the compensation through their provision of services is the employer’s satisfaction of the all-events test for the deduction of the vacation and bonus pay expense itself in this tax year. As provided in Rev. Rul. 96-51, and in Eastman Kodak with regard to payroll taxes on earned but unpaid wages, the obligation to pay the taxes was established (satisfaction of the all-events test) as an automatic consequence of the definite obligation to pay the earned wages. In response to fixing the all-events test for the vacation and bonus pay expense in Eastman Kodak, the IRS did not challenge the taxpayer’s deduction of the vacation and bonus pay expense for the tax year the employees earned the compensation through their provision of services because there were no termination-of-pay provisions in Eastman Kodak’svacation and bonus pay plans.

Unlike the vacation and bonus pay plans described in Eastman Kodak, it is fairly common for taxpayers’ vacation and bonus pay plans to contain termination-of-pay provisions. Although an employee “earns” vacation and bonus pay through the provision of services as of the end of the employer’s tax year, a termination-of-pay provision could result in the employee’s forfeiture of such vacation and bonus pay if a described event occurs in the employer’s subsequent tax year prior to the employee receiving the payment for vacation and bonus pay. As indicated above, the most common termination-of-pay provisions for vacation pay plans are “use or lose” and “termination for cause” conditions. For bonus pay plans, the most prevalent termination-of-pay provision is an “employment on bonus payment date” condition. The question at hand is whether the existence of these common termination-of-pay provisions precludes the taxpayer’s satisfaction of the all-events test for the tax year in which the employees earn the vacation and bonus pay through their provision of services.

Vacation pay expense: It would appear that there is at least substantial authority for an accrual-method taxpayer to deduct vacation pay expense for the tax year in which employees render services (assuming the payment of expense is made within 2½ months of tax year end), even though at the end of that tax year there is a possibility that a portion of the vacation pay expense might be forfeited by employees because of the operation of use-or-lose or termination-for-cause provisions. Ex-isting precedent supports the position that provisions in vacation pay plans may be viewed as “conditions subsequent” and/or “remote contingencies,” the possible occurrence of which does not preclude the satisfaction of the all-events test.

The authority for the “condition subsequent” analysis is drawn from:

  1. Technical Advice Memorandum 199934002 (use-or-lose or termination-for-cause provisions in a vacation pay plan are conditions subsequent that do not prevent the accrual of the expense deduction);
  2. Masonite Corp. v. Fly, 61-1 USTC ¶9355 (S.D. Miss. 1961) (a voluntary/involuntary termination provision in the taxpayer’s vacation pay plan is a condition subsequent that does not postpone the deduction of the expense for the tax year in which the employees earned the vacation pay);
  3. Russian Finance Construction Corp., 77 F2d 324 (2d Cir. 1935) (in which a contract had a fixed price component due when ore was delivered, and royalties of $2 per ton were payable 10 years after the agreement was signed, but the contract was subject to cancellation if one of three contingencies occurred; the Second Cir-cuit held that the liability to pay royalties arose on delivery of the ore and the contingencies were conditions subsequent); and
  4. Rev. Rul. 58-18 (which, although focused on whether a vacation pay plan must be in writing to permit the accrual of the vacation pay expense deduction, indicates that a use-or-lose provision will not prevent accrual of the vacation pay expense).

The authority for the position that termination-of-pay provisions in a vacation pay plan are “remote contingencies” that do not preclude the satisfaction of the all-events test is drawn from:

  1. Hughes Properties, Inc., 476 US 593 (1986) (the extremely remote and speculative possibility that progressive jackpot expense amounts might never be won did not change the fact that the last play of each progressive slot machine before the end of the tax year fixed the casino’s liability to pay the progressive jackpot amount);
  2. Gold Coast Hotel & Casino, 158 F3d 484 (9th Cir. 1998) (an accrual-method casino could deduct the value of slot club points won by a club member for the tax year in which the member accumulated the minimum number of points necessary to redeem a prize; the casino’s liability was not rendered conditional by the possibility that some of the points accumulated by members might go unredeemed).

Bonus pay expense: There would also appear to be substantial authority for an accrual-method taxpayer to deduct bonus pay expense for the tax year in which the employees render services (assuming payment of expense is made within 2½ months of tax year end), even though at the end of that tax year there is a possibility that a portion of the bonus pay expense might be forfeited because of the operation of an “employment on payment date” provision in the taxpayer’s bonus pay plan. This opinion is drawn from the view that employment-on-payment-date provisions in bonus pay plans constitute conditions subsequent and/or remote contingencies, the possible occurrence of which does not preclude the satisfaction of the all-events test. The authority for this position is derived from the cases, the revenue ruling, and the letter ruling cited above for the deduction of vacation pay expense in the tax year the employees provide services. Additional authority is derived from Burnham Corp., 90 TC 953 (1988), aff’d, 878 F2d 86 (2d Cir. 1989), in which the Tax Court held (citing Hughes Properties) that the taxpayer’s liability to pay a patent infringement expense was fixed for the tax year in which the taxpayer entered into a settlement agreement with the payee, even though a portion of the expense was conditioned on the payee’s survival on the payment due dates.

Authority contrary to the position that the existence of employment-on-payment-date provisions in bonus pay plans does not preclude the satisfaction of the all-events test in the tax year the employees provide services is derived from Bennett Paper Co., 699 F2d 450 (8th Cir. 1983). In Bennett Paper, the Eighth Circuit held that a bonus pay expense was not fixed for the tax year of employee services because of the possibility of employee forfeiture of the bonus pay that was attributable to the voluntary or involuntary termination of the employee’s employment relationship prior to the bonus pay payment date. (In light of the infrequent occurrence of the forfeiture provision in Bennett Paper, it would appear that this case was essentially nullified by the subsequently decided Hughes Properties decision.)

Deduction of Payroll Taxes on Vacation and Bonus Pay

As indicated above, the court in Eastman Kodak held that the taxpayer’s obligation to pay the payroll taxes on vacation and bonus pay was “not certain”; thus, the all-events test was not satisfied for the payroll taxes on the vacation and bonus pay for the tax year in which the employees earned the compensation. The court in Eastman Kodak reasoned that because of the yearly FICA and FUTA wage ceilings, the obligation to pay those taxes was not fixed and certain as of the last day of the employer’s tax year in which the employees earned the compensation. If an employee was over the payroll tax wage ceilings on the date the vacation and bonus pay was paid, the employer would not have any payroll tax liability. Because the payroll tax wage ceilings were so low in 1964 (the tax year at issue), the court in Eastman Kodak thought there was a real possibility that the tax would not be paid.

It is not clear how the IRS will apply the payment-is-certain criteria set forth in the Eastman Kodak decision. In light of the significant increases in the payroll tax wage ceilings since 1964 and the fact that Rev. Rul. 2007-12 revoked Rev. Rul. 69-587, it is likely that the IRS will permit taxpayers under certain circumstances to change to an accounting method by which they will be allowed to deduct at least some payroll taxes on vacation and bonus pay expense for the tax year in which the employees earn the underlying compensation. A projection of these certain circumstances is described below.

Medicare (Vacation and Bonus Pay)

The Medicare rate (1.45%) within the FICA tax has no wage ceiling. Thus, there would seem to be no basis for the Service to deny an accounting method request to change to the method of deducting the Medicare portion of the FICA tax on the vacation and bonus pay expenses of all employees for the tax year in which the employees earn the compensation, assuming that:

  • The taxpayer satisfies the all-events test for the deduction of the vacation and bonus pay expense for the tax year of employee service; and
  • The taxpayer pays the Medicare portion of the FICA tax on the earlier of the date the taxpayer files its return for the tax year of employee service or 8½ months after the end of this tax year. Payment of the tax satisfies the economic performance requirement of Sec. 461, and payment of the tax within the above-described time frame of the recurring-item exception allows the taxpayer to deduct the tax for the tax year the all-events test is met. To use the recurring-item exception, there is no requirement that the taxpayer on the last day of its earlier tax year have “certainty” that economic performance will be satisfied within the recurring-item exception time frame. Thus, for example, a taxpayer that files its returns on an extended due date basis and pays the payroll tax within 8½ months of the earlier tax year end would be entitled to the deduction for the earlier tax year. If the taxpayer does not pay within 8½ months, the taxpayer would not be entitled to the deduction for the earlier tax year. This should be compared withthe “3½ month” rule set forth in Regs. Sec. 1.461-4(d)(6)(ii), in which economic performance is deemed to be satisfied on the prepayment of a service or property expense, if the taxpayer on the date of prepayment “can reasonably expect” that the services or property will be provided within 3½ months from the date of prepayment.

OASDI (Bonus Pay)

The OASDI rate (6.2%) within the FICA tax has a wage ceiling of $97,500 for calendar year 2007 and $102,000 for calendar year 2008. If (1) the taxpayer uses a calendar tax year, (2) the liability to pay the bonus expense fixes in the tax year of employee service, and (3) the taxpayer pays the bonus expense within 2½ months of tax year end, then the IRS will presumably grant permission for the taxpayer to change to the accelerated method for the deduction of the OASDI portion of the FICA tax on bonus expense for an employee bonus pool (determined individually) that comprises employees whose quarterly compensation (including possible raises in salary) does not approach the wage ceilings.

For taxpayers that use a fiscal tax year and satisfy (2) and (3) above, the employee bonus pool included in the change to the accelerated method for the deduction of the OASDI portion of the FICA tax on bonus expense will generally be smaller than the employee pool of a taxpayer of the same size that uses a calendar tax year (except for taxpayers that use a fiscal tax year ending October 31 or November 30). This is because the FICA tax wage ceilings are applied on a calendar-year basis. Thus, for example, a taxpayer that uses a tax year ending June 30 will use an employee bonus pool that comprises employees whose compensation for nine months (including possible raises in salary) does not approach the wage ceilings.

OASDI (Vacation Pay)

Assuming the taxpayer’s employees do not schedule in advance their vacation time on or before the last day of the taxpayer’s tax year in which the employees earn the vacation pay, the taxpayer’s employee pool, for purposes of changing to the accelerated method for deducting the OASDI portion of the FICA tax on vacation pay expense, will comprise employees whose annual compensation (including possible raises in salary) does not approach wage ceilings. This employee pool can be expanded to include employees whose annual compensation is above the ceilings but whose vacation leave has been scheduled in advance for a date on which their compensation will be below the ceilings. This employee pool is unaffected by whether the taxpayer uses a calendar or fiscal tax year. Remember, of course, that the taxpayer will deduct the FICA tax in the earlier year only if the tax is paid within 8½ months of such tax year end (assuming the taxpayer files its return on an extended due date basis).

FUTA and State Unemployment Taxes (Vacation and Bonus Pay)

The FUTA rate (6.2%) is payable on the first $7,000 of compensation paid to employees. Assuming that the state unemployment taxes payable by a taxpayer have wage ceilings in the same range as FUTA, there would seem to be very little opportunity to accelerate the deduction of FUTA and state unemployment taxes on vacation and bonus pay. It would seem that most, if not all, of a taxpayer’s employees would have received compensation that exceeded the ceilings at the time they were paid the bonus and vacation pay.


EditorNotes

Jeff Kummer, MBA is Director of Tax Policy at Deloitte Tax LLP, Washington, DC.

If you would like additional information about these items, contact Mr. Kummer at (202) 220-2148 or jkummer@deloitte.com.

This article does not constitute tax, legal, or other advice from Deloitte Tax LLP, which assumes no responsibility with respect to assessing or advising the reader as to tax, legal, or other consequences arising from the reader’s particular situation.

Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.

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