It is common practice for an employer to maintain an annual bonus plan to attract, retain, and provide incentives to employees who are key to the business’s growth. Employers often spend a great deal of time designing a bonus plan to meet these goals. But employers should not stop there. They should also consider how the bonus arrangements affect their income tax obligations at the end of the year.
In most circumstances, the optimal outcome is for the employer to deduct the bonus in the year it is earned, rather than the year it is paid. Many businesses believe that as long as they pay the bonuses within 2½ months after the end of the tax year in which the bonus is earned, the bonus is deductible in the year it is earned, rather than the year paid. Unfortunately, this is not always true. Many factors determine when the bonus is deductible.
This item focuses on an employer’s ability to deduct bonuses in the tax year they are earned rather than the tax year in which they are paid to the employee. This includes a discussion of a recently released IRS field attorney memorandum (Field Attorney Advice (FAA) 20134301F). This item refers to ABC Co., a hypothetical employer that uses the accrual method of accounting, and its employee, Tom, to illustrate the deduction timing rules. ABC is a calendar-year taxpayer that pays the bonus to Tom within 2½ months after the end of ABC’s tax year in which Tom earns the bonus (i.e., by March 15), which avoids the deduction timing rules under Sec. 404 that apply to deferred compensation and that may result in deferring the deduction until the year it is paid.
Assuming ABC pays Tom his bonus within 2½ months after the end of the tax year in which Tom earns the bonus, Sec. 461 governs the timing of ABC ’s tax deduction. If ABC were a cash-basis taxpayer, the timing of the deduction would be simple. Regs. Sec. 1.461-1(a)(1) allows the deduction in the year the bonus is paid. If ABC were a cash-basis taxpayer and paid Tom his 2013 bonus in February 2014, ABC would deduct the bonus in 2014.
The Sec. 461 rules are much more complex when considering an accrual-method taxpayer. Regs. Sec. 1.461-1(a)(2) provides that under an accrual method of accounting, a liability (e.g., an accrued bonus) is incurred, and generally deductible, in the tax year in which (1) all events have occurred to establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred for the liability. The first two prongs are referred to as the all-events test. This test has received increased attention over the past few years in the form of official and unofficial IRS guidance. These two prongs are the subject of this item. The third prong, economic performance, is satisfied when the employee performs the services related to a bonus. This prong has not received increased attention.
As discussed above, the all-events test is met in the tax year in which (1) all events have occurred to establish the fact of the liability, and (2) the amount of the liability can be determined with reasonable accuracy. When is the fact of a liability established? In Rev. Rul. 79-410, the IRS addressed how the all-events test applies to a noncompensation accrued liability. In this ruling, the IRS stated that “all events have occurred that determine the fact of the liability when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment therefore is due, whichever happens earliest.”
First, it is important to consider how this would apply if a separate bonus plan is in place for each employee, including Tom. Suppose Tom is required to be employed only on the last day of the tax year to receive the bonus payment, rather than the bonus payment date. The amount of Tom’s bonus is determined based on an objective formula established before the end of the tax year that takes into account ABC ’s financial data as of the end of the year. Generally, the fact of the liability is established on Dec. 31, 2013, and the amount of the liability is determinable at that time. However, as discussed later, other provisions of the bonus plan may cause the fact of the liability not to be established until 2014, when the bonus is paid.
Alternatively, suppose the facts are the same as above, but Tom is required to be employed on the bonus payment date to receive the bonus. If he leaves before the bonus payment date, ABC retains the bonus. In this instance, the event fixing the liability for the bonus is the payment date because Tom is required to be employed on that date. If Tom leaves before that date, ABC is not required to pay the bonus to Tom or any other employee. Thus, all events occur to establish the fact of the liability on the bonus payment date in 2014, resulting in a deduction for the bonus in 2014.
Other factors may cause the fact of the liability to be established, and the amount of the liability to be reasonably determinable, in 2013, even if the employee is required to be employed on the bonus payment date to receive the bonus. This typically occurs in situations where the accrued bonus is related to a group of employees instead of a single employee.
For example, an employer may use a “bonus pool” strategy, in which a bonus pool is allocated to employees. The amount in the pool is determined either (1) through a formula that is fixed before the end of the tax year, taking into account financial data reflecting results as of the end of the tax year, or (2) through some other binding corporate action that specifies the pool amount, such as a board resolution made before the end of the tax year.
Under ABC’s bonus pool, Tom and the other employees are allocated a portion of the bonus pool, but to receive the bonus payment, the employees must be employed on the bonus payment date. If Tom forfeits the bonus because he is no longer employed on the bonus payment date, his bonus is reallocated to the other employees who remain with the company on that date. Thus, ABC will pay the entire amount of the bonus accrual to employees. In this situation, ABC’s bonus liability is fixed at the end of the tax year because it will pay the aggregate amount of the bonuses. Also, the amount of the bonus liability is reasonably determinable on Dec. 31, 2013, because the amount is established through a formula or board resolution in place on that date.
The company may also employ a “minimum bonus” strategy, which uses the bonus pool concept but allows the employer to retain a specified amount of forfeited bonuses rather than reallocating them to other employees. Similar to the bonus pool concept, before year end, ABC establishes an aggregate amount of bonuses that will be paid to the group of employees. It also sets a minimum amount of the aggregate bonus pool that ABC will pay to employees and determines this minimum amount by analyzing the trend of forfeited bonuses in prior years.
For example, over the past five years, on average, 6% of bonuses have been forfeited by employees who left before the bonus payment date. To be conservative, ABC estimates that employees will forfeit no more than 10% of the aggregate bonuses, and before the end of the tax year, mandates that it will pay out at least 90% of the aggregate bonus amount to employees. To the extent that the bonuses actually paid to employees are less than 90% of the aggregate bonus amount, ABC pays additional bonuses to reach the 90% threshold.
The IRS considered this minimum bonus strategy in Rev. Rul. 2011-29 to determine whether the fact of the bonus accrual liability is established at year end. The IRS recognized that the employer is obligated under the bonus plan to pay the group of employees the minimum amount of the bonuses determined by the end of the year. Applying this to ABC ’s bonus, the liability is established at the end of the year for 90% of the aggregate bonus pool. The fact of the liability for any bonuses paid in excess of the 90% minimum amount is not established until those bonuses are paid. The IRS didn’t consider the second prong of the all-events test—when is the amount of the liability determinable with reasonable accuracy—in Rev. Rul. 2011-29, but it is clear that the amount was determined on the last day of the tax year because of the fixed formula or board resolution. Thus, assuming economic performance occurred on Dec. 31, 2013, under Rev. Rul. 2011-29, ABC may deduct the 90% minimum bonus amount in 2013 and deduct any amount paid in excess of the minimum amount in 2014.
Traps for the Unwary
In FAA 20134301F, the IRS analyzed when an employer could take a tax deduction for bonuses paid to employees. The employer in this memorandum sponsored multiple bonus plans that paid cash awards to employees. The employees had to be employed on the last day of the tax year to receive the bonuses, but not on the bonus payment date. The bonus was paid after the end of the employer’s tax year, but within 2½ months after the end of the tax year. The scenario described above considered the situation where Tom was required to be employed on the last day of the tax year but not on the bonus payment date. Under that scenario, the all-events test was met on the last day of the tax year. In the field attorney memorandum, however, the IRS pointed out factors that could cause the bonus liability not to meet the all-events test at the end of the tax year.
The plans in the memorandum provided that the employer retains the unilateral right to modify or eliminate the bonuses at any time before payment. The IRS concluded that the bonus plans did not meet the all-events test until the bonuses were paid to the employees, because the fact and amount of the liability were not established until that date. Because the employer had the right to unilaterally eliminate or reduce the bonuses at any time prior to payment, the employer had no legal obligation to pay the bonuses. As a result, according to the memorandum, the all-events test was not met at the end of the tax year.
The IRS considered a number of nontax court cases in reaching this conclusion. The cases focus on state law and an employer’s legal obligation to pay compensation to employees when the employer retains the unilateral right not to pay the compensation. The IRS concluded that this type of unilateral right did not create a contract between the employer and employee. Even if it did create a contract, there would be no breach of contract for failure to pay the bonuses. As a result, the bonus plan did not fix the employer’s liability to pay the bonuses prior to payment of the bonuses.
Some of the bonus plans addressed in the memorandum compute the amount of the bonuses using preestablished objective performance criteria. The employer did not pay the bonuses to the employees until after a committee of the employer’s board of directors approved the bonus plan payment, which did not occur until after the end of the tax year. The committee had the ongoing right to adjust the bonuses before they were paid. The IRS found that the committee’s approval was more than a ministerial act. Thus, according to the memorandum, the all-events test was not met until the committee approved the bonuses and their payment, because no bonus was paid without the committee’s approval, which was not automatic. Thus, the employer did not meet the all-events test as of the end of the tax year.
The formulas used to calculate the employees’ bonuses discussed in the memorandum are driven by one or more metrics, some of which are not fixed at year end. In some instances, the formula takes into account the employee’s individual performance appraisals, which are not conducted until after the end of the year, and therefore are not fixed at year end. The IRS concluded that where bonus amounts are dependent in whole or in part on some subjective determination made after year end (e.g., a performance appraisal), the all-events test is not met at year end because the subjective determination is one event that fixes the fact and amount of the liability.
This field attorney memorandum demonstrates the importance of paying close attention to a bonus plan’s provisions. A plan provision that gives the employer discretion to adjust or eliminate the bonus amount after the end of the tax year likely results in the all-events test’s not being met at the end of the tax year. Also, using a formula to determine the amount of the bonus may be an optimal design strategy, but a formula that looks at subjective factors after the end of the tax year is a fatal flaw when attempting to meet the all-events test on the last day of a tax year.
Public Companies: Sec. 162(m)
Public corporations that attempt to avoid the $1 million compensation deduction limitation in Sec. 162(m) may find challenges when they also attempt to deduct bonuses in the year bonuses are earned rather than the year the bonuses are paid. In general, Sec. 162(m) limits a public corporation’s annual income tax deduction to $1 million for compensation paid to a covered employee. A covered employee includes the corporation’s principal executive officer and the three highest-paid executives other than the principal executive officer and principal financial officer. Performance-based compensation is not subject to the $1 million compensation deduction limitation. Public company employers often structure executive bonus plans to meet the performance-based compensation requirements.
To qualify as performance-based compensation, the corporation must establish the compensation plan within 90 days of the beginning of the performance period and must state, in terms of an objective formula or standard, the method for computing the amount of compensation payable to the executive. The plan may not allow for discretion to increase the amount payable, but it may provide for discretion to reduce or eliminate the compensation payable under the plan.
For example, ABC implements the bonus pool strategy for the bonus plan in which the executives participate. Under this strategy, if Tom leaves before his bonus is paid, he forfeits the bonus, and ABC allocates it to the other executives. Thus, ABC has discretion to increase the bonuses payable to the other executives, which violates the performance-based compensation requirements if the other executives are covered employees.
This same conclusion is reached if ABC implements the minimum bonus strategy, because if the total amount of the bonuses paid to the executives does not reach the minimum percentage, ABC must allocate additional bonuses to the other executives who are covered employees. Thus, it may not be practical for a public company to use one of these strategies for its executive bonus plan.
This does not mean it is impossible for a public company’s executive bonus accrual to meet the all-events test in the performance year while also qualifying as performance-based compensation. The plan may provide that the executives are required to provide services only until the last day of the tax year. In that situation, the all-events test generally is met on that date. Alternatively, under the bonus pool strategy, the plan may provide that any executive who is not employed on the bonus payment date forfeits the bonus, but the forfeited amount will not be reallocated to covered employees. A corporation can apply the same approach to the minimum bonus strategy.
Some public companies have implemented what sometimes is referred to as a “plan within a plan” for paying bonuses to covered employees. The plan states that the company will pay a very high bonus target amount to the covered employee if the performance goals are met. The plan then gives the compensation committee discretion to reduce the bonus amount, often taking into account subjective performance goals. This gives the compensation committee discretion to pay the executive what it deems appropriate, as long as the high bonus target is not exceeded. Unfortunately, this type of discretion results in the all-events test’s not being met until the bonus is paid to the employee. The fact of the liability is not established on the last day of the tax year because the compensation committee can reduce the bonus amount after the end of the year.
Determining the deduction timing of accrued bonuses is not as simple as it may seem. Merely paying the bonus within 2½ months after the end of the tax year will not always result in a deduction in the bonus performance year rather than the year the bonus is paid. Employers and tax return preparers should pay close attention to the provisions and operations of the bonus plan before reaching a conclusion on the timing of the deduction. All is not lost for employers that require their employees to still be employed on the bonus payment date to receive payment. Employers can implement strategies so the all-events test is met at the end of the tax year. However, traps for the unwary can ruin good intent.
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, D.C.
For additional information about these items, contact Mr. Fairbanks at 202-521-1503 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.