The IRS Office of Chief Counsel has concluded that a liability arising from bonus compensation is deductible in the year the bonus is paid if payment of the bonus is contingent on the taxpayer’s employees being employed on the payout date. Chief Counsel Advice (CCA) 200949040 affirms the view held by many tax practitioners that an employment contingency within the bonus or incentive compensation plan prevents the all-events test from being met at year end under Sec. 461 even though the bonus is paid within the 2½-month period after the end of the tax year in which the bonus is earned.
The taxpayer for which the CCA was issued is a corporation that uses the accrual method of accounting for federal income tax purposes. The taxpayer offers a nonexecutive incentive compensation plan to certain employees. The plan requires employees to be employed by the taxpayer on the date that bonuses are paid in order to receive them. Any bonuses not paid to an employee are forfeited and revert back to the taxpayer. The facts further indicate that the taxpayer had previously filed an advance consent Form 3115, Application for Change in Accounting Method, to change its method of accounting to treat bonuses as incurred in the tax year in which all events occurred to establish the fact of the liability; the amount of the liability can be determined with reasonable accuracy; and economic performance has occurred with respect to the liability.
After signing the consent letter for the Form 3115, the taxpayer obligated itself to pay 90% of the amount accrued for financial statement purposes with respect to the bonus related to year 1 within the first 2½ months of year 2. Amounts not paid to employees would be paid to a charity as a charitable contribution. The 90% obligation was not made a part of the existing nonexecutive incentive compensation plan. Further, it was not communicated to the employees in year 1 because it did not alter the bonus plan or terms for the employees. Instead, the 90% obligation was expressed in a memorandum to files from the company’s president/CEO and executive vice president/CFO. In year 1, no charitable contribution was made because bonuses in excess of the 90% threshold were in fact paid within the first 2½ months of year 2.
Bonus compensation payments are generally deductible as an ordinary and necessary trade or business expense under Sec. 162, provided that two tests are met: (1) the all-events test under Sec. 461 and (2) the 2½-month rule under Sec. 404.
The first test for the deductibility of bonus payments, typically referred to as the all-events test, is described in Sec. 461 and the regulations thereunder. Regs. Sec. 1.461-1(a)(2)(i) provides that under an accrual method of accounting, a liability is incurred, and is generally taken into account for tax purposes, in the tax year in which all the events have occurred that establish the fact of the liability; the amount of the liability can be determined with reasonable accuracy; and economic performance has occurred with respect to the liability. Sec. 461(h)(1) states that in determining whether an amount has been incurred for any item during the tax year, the all-events test will not be treated as met any earlier than when economic performance with respect to the item occurs. Regs. Sec. 1.461-1(a)(2)(iii)(D) provides, in part, that the economic performance requirement is satisfied to the extent that any amount is otherwise deductible under Sec. 404 (relating to employer contributions to a plan of deferred compensation).
The deductibility of deferred compensation paid under a plan or arrangement is subject to the limitations of Sec. 404 and the regulations thereunder, which generally provide that the employer’s deduction is delayed until the employee includes the amount in income. However, if the compensation is paid on or before the 15th day of the third calendar month after the end of the employer’s tax year in which the related services are rendered, the deferred compensation rules do not apply (the 2½-month rule).
With respect to charitable contributions, Regs. Sec. 1.461-1(a)(2)(iii)(B) provides that if a liability is subject to Sec. 170 (relating to charitable contributions), the liability is taken into account as determined under that section and not under Sec. 461. Sec. 170(a)(2) sets forth that in the case of an accrual-basis corporation, if the board of directors authorizes a charitable contribution during any tax year, and payment of such contribution is made after the close of that tax year and on or before the 15th day of the third month following the close of the tax year, the taxpayer may elect to treat the contribution as paid during the tax year.
Chief Counsel Advice Analysis
As a preliminary matter, the IRS cited well-established law that in order to satisfy the all-events test for determining when an item is incurred for federal income tax purposes, the liability must be final and definite in amount, must be fixed and absolute, and must be unconditional. Liabilities meet the all-events test only to the extent that they are firmly established and not contingent, according to the IRS. Because the bonuses in this case were paid under a plan that required the employees to be employed by the taxpayer on the payout date in order to receive that compensation, the IRS found that the liability for the bonuses was subject to a contingency.
The CCA commented that the taxpayer did not know at the end of year 1 whether it owed bonus compensation to any employee. As a result, the liability to pay the bonus under such a plan was not a fixed liability in the year of the related service (year 1) but became fixed only when the contingency was satisfied (year 2)—that is, when the employee was still employed on the date of payment and received the bonus. Perhaps more significantly, the IRS noted that even though bonuses were based on the taxpayer’s performance in year 1, “economic performance does not occur and the liability is not fixed until the date that bonuses are paid because service must continue until that time,” citing the economic performance rule for services and property provided to a taxpayer under Regs. Sec. 1.461-4(d)(2).
Based on the foregoing rationale, the IRS held that the taxpayer’s liability for bonus compensation was deductible in the year the bonuses were paid. Further, the IRS concluded that the taxpayer was not entitled under Sec. 170(a)(2) to accrue a liability for a charitable contribution in year 1 because the taxpayer did not in fact make any charitable contributions. The CCA found unpersuasive the taxpayer’s argument that it had a fixed and determinable liability at the end of year 1 for 90% of the amount accrued for financial statement purposes for year 1, including an obligation to contribute any unpaid amounts to charity, and therefore it was entitled to deduct that amount in year 1 under Secs. 404(a) and 461. Noting that Secs. 170 and 461 apply to different types of liabilities and provide different timing rules, the IRS said that the failure to contribute amounts to charity does not mean that the taxpayer necessarily satisfies the requirements of Sec. 461.
Taxpayers that currently deduct bonus payments without considering whether the all-events test has been met at year end may be subject to exposure on audit. CCA 200949040 affirms the view held by many tax practitioners that an employment contingency prevents the all-events test from being met at year end under Sec. 461 even though the bonus is paid within the 2½-month period after the end of the tax year in which the bonus is earned. Taxpayers who may have exposure for deducting bonuses before the all-events test is met due to the employment contingency or other factors may wish to consider altering their bonus plans (for example, removing the employment contingency) or filing an accounting method change under the automatic procedures of Rev. Proc. 2008-52 (as modified by Rev. Proc. 2009-39) to change to a proper method of accounting and secure audit protection for prior years.
Editor: Kevin D. Anderson, CPA, J.D.
Kevin Anderson is a partner, National Tax Services, with BDO Seidman, 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 Seidman, LLP.