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The end of the calendar year is associated with many pleasant things—the holiday season, spending time with family and friends, time off from work, and, in some cases, bonuses from an employer. If the bonus is paid to the employee before year end and the accrual-method employer's liability is incurred so that the employer is able to take a deduction by year end, both parties are probably pretty happy.
If an employer has been mistakenly taking a deduction in the earlier year (i.e., the year of services), the employer may be using an improper accounting method and (assuming it does not want to revise its bonus plans to eliminate the retained discretion) may have to request an accounting method change to correct the treatment and protect itself from exposure for prior-year treatment. Although inherently a timing issue, this could create a permanent impact for employers if income tax rates decrease in future years or for employers that are organized as flowthrough entities, where the owners are subject to higher income tax rates, and lead to exposure and the risk of penalties and interest for employers that are improperly recognizing the deduction in the year before payment is made.
Although the proper timing for recognizing a bonus liability and taking the deduction for bonus payments is not a new issue, tax practitioners continue to find employers using impermissible methods of taking the deduction in a year prior to when it should be taken under accrual-method rules. Many times, this issue is discovered when an employer engages a new tax preparer or a new auditor. For financial statement purposes, employers using U.S. GAAP may be taking the liability into account in the year the related services are provided. While this may be acceptable for GAAP purposes, for federal income tax purposes the liability might not be deductible until the following year. Thus, employers that currently are following book treatment and are not calculating a Schedule M-1 or M-3 adjustment on their return for bonus liabilities should, in particular, consider reviewing their bonus plans to determine whether such treatment is permissible.
This article discusses issues related to bonus liabilities of employers on the accrual method of accounting, when the bonuses are paid after the tax year in which the related services are performed by the eligible employee(s) but within 2½ months after the year end. 1 This article describes when a liability generally is incurred and becomes deductible under the accrual-method rules and how these rules affect the timing of when bonus liabilities in particular may be deductible by accrual-method employers. 2 This article also discusses steps a taxpayer that is on an impermissible method of accounting for bonus liabilities may take to limit exposure for prior improper treatment and to correct treatment for current and future years.
Although this article provides a high-level overview of the rules regarding deducting bonus compensation liabilities for accrual-method employers, it is not intended to provide an all-encompassing discussion of every issue such liabilities may raise. 3 Practitioners should make sure to examine the client's specific facts and circumstances prior to determining the appropriate treatment of bonus liabilities and prior to taking any steps to change present treatment.When Is a Liability Incurred for Federal Income Tax Purposes?
Accrual-method employers generally must wait until a liability is incurred before it can be taken into account (either through deduction or capitalization, as applicable). 4 The general rules for when a liability is incurred are provided in Sec. 461 (and the related regulations) and Regs. Sec. 1.446-1(c)(1)(ii). These rules for determining when a liability is incurred for federal income tax purposes are thus the foundation of identifying a deductible liability for a given tax year.
Under Sec. 461 and attendant regulations, for federal income tax purposes, a liability generally is taken into account by an accrual-method taxpayer 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. 5 Thus, such taxpayers are subject to a three-prong test for incurring a liability.
The economic performance rules vary depending on the type of liability, and for many other liabilities economic performance is the last event to occur. Because the employer's liability for bonuses arises out of another person's providing services to the employer, economic performance occurs as that person provides the services. 6 Therefore, in the case of bonus liabilities that arise out of services provided by an employee, by the end of the tax year in which the services giving rise to the bonuses are performed, the taxpayer will generally have met the economic performance requirement with respect to the liability. 7
Even though economic performance may have occurred for a liability, the liability must also be fixed for a taxpayer to recognize it for federal income tax purposes.In many bonus liability issues seen today, fixing of the liability happens last and is thus often the biggest obstacle employers with discretionary bonus plans face in determining when the liability for such bonuses is incurred and thus deductible for tax purposes. Generally, under Regs. Sec. 1.461-1(a)(2), all the events have occurred that determine the fact of the liability at the earlier of (1) the event fixing the liability occurs, whether that is the required performance or other event, or (2) payment therefore is due. 8 In General Dynamics Corp., 9 the Supreme Court noted that
[i]t is fundamental to the "all events" test that, although expenses may be deductible before they have become due and payable, liability must first be firmly established. This is consistent with our prior holdings that a taxpayer may not deduct a liability that is contingent . . . or contested. 10
Issues Affecting the Fixing of Bonus Liabilities
Many discretionary bonus plans include language and provisions that, in the IRS's (and many courts') view, will keep the liability from fixing until any uncertainty created by that discretion is eliminated. Ultimately, in court opinions and IRS guidance, the key factor in determining whether an employer has a fixed liability for bonus payments appears to be whether that employer has a legal obligation to pay the bonuses.
For instance, often, an employer's bonus plan will require an employee to be employed on the date of the payout to remain eligible to receive the bonus. If the plan does not also include a provision requiring any forfeited bonuses to revert to a pool to be paid out to the remaining eligible employees, this restriction will keep the liability from fixing (and thus meeting the all-events test under Sec. 461) until the tax year in which payment is actually made.In Bennett Paper Corp., 11 the Tax Court held that a taxpayer that, as part of its employee bonus plan, required the employees to remain in the taxpayer's employment until payment was made to be eligible for the bonus, did not have a fixed liability until payment was actually made. The court noted that the requirement of employment on the date of payment was a contingency that rendered the taxpayer's liability to pay the bonus uncertain and thus "unfixed" until that contingency was eliminated.
However, in The Washington Post Co., 12 the Court of Claims held that the taxpayer, a newspaper publisher, did have a fixed bonus liability upon amounts credited to a fund to reward dealers for their contribution to the taxpayer's success. A dealer could forfeit its right to payment from the fund by terminating its contractual relationship with the taxpayer. However, any forfeited amounts would be reallocated to a pool to be paid out to the remaining eligible dealers. Thus, amounts credited to the fund were in all cases to be paid by the taxpayer, even though the identity of the payees remained uncertain. Because of this reallocation provision, the court held that while the amount may not have been fixed as to a particular dealer, once it was credited to the fund as a whole, the taxpayer had a fixed liability to pay that amount. 13
The IRS initially took the position that it would not follow the holding in The Washington Post Co., stating that the all-events test could be met only when the "fact of the liability to a specified individual participant has been clearly established." 14 However, in 2011, the IRS reversed its position on this issue and ruled that a liability may meet the fixed-and-determinable prong of the all-events test prior to payment even where the identity of the specific payees remains unknown until payment is actually made. 15
Additionally, if a discretionary bonus plan requires the employer's board of directors (or a similar authority) to approve a payment before it is made, such approval must occur before the liability becomes fixed for federal income tax purposes. This will affect the employer's deduction, for example, where the bonus plan creates a bonus pool based on a year-end metric but specifically provides that the employer is not obligated to pay out any amount unless and until the board's compensation committee reviews and approves the payment. Because those reviews generally occur only after the close of the year, when financial results are available, the employer's retained discretion to alter the extent to which the bonus pool will be distributed may prevent the fixing of the liability until that next year.
Further, if the board resolution does not create a legally enforceable right to the bonuses, the liability still may not be fixed until the employer does become legally obligated to make the payment (which might not be until the actual payment date). For instance, in Bauer Bros. Co., 16 the Sixth Circuit held that a taxpayer's liability to pay bonuses to its employees did not fix when, prior to the end of the year, the taxpayer's board of directors informally voted to pay out bonuses to its employees but did not make any accounting entries on its books or provide any written memoranda relating to the bonuses. Ultimately, this informal vote by itself was not enough to fix the taxpayer's liability since it did not result in a "legal obligation which could be enforced, either on the basis of express or implied contract." 17
Alternatively, in Willoughby Camera Stores 18 the Second Circuit held that a taxpayer did have a fixed liability to pay bonuses when in December each year its board of directors passed a resolution approving the payment of bonuses during the next year, issued a written memorandum to this effect to its treasurer, who credited a reserve account to pay them, and notified its employees. In the court's view, these actions were enough to provide a legal obligation (in the form of an implied contract between the taxpayer and its employees) to provide the bonuses.
In 2013, the IRS Office of Chief Counsel (OCC) advised in a legal advice memorandum 19 that an employer's bonus plans retaining with the employer the legal right to modify or rescind payment of bonuses at any time prior to payment caused the liability to not fix until payment. The taxpayer provided several bonus plans under which employees could receive cash bonuses that were calculated based on achieving various metrics at the company and individual levels. After the end of each year, the taxpayer's board of directors would review and approve bonuses. Although the amount of bonuses was based on metrics determinable as of the end of the year in which the related services were provided, the board had complete discretion to modify the amounts of individuals' bonuses and could even decide not to pay any bonuses. Because the taxpayer had a unilateral right to modify the plan or eliminate the bonuses, the IRS determined that the taxpayer had no liability under the bonus plan until the bonuses were paid. Although legal advice memoranda are not to be used as precedent, this guidance does provide insight into how the IRS may analyze a particular taxpayer's bonus plans to determine when the liability fixes under the all-events test. 20
It would appear, based on court holdings and the IRS's stated position in revenue rulings and other guidance, that the government is likely to assert that an employer's retention of discretion to alter whether and how much it will pay out in bonuses after the end of the service year will keep the liability from fixing until the contingency (whether it is board approval, payment, etc.) is eliminated. If it is determined that an employer is improperly accounting for its bonus liabilities, the next issue to consider is how an employer may correct its treatment and protect itself in the process.How to Correct Improper Treatment of Bonus Liabilities
If it is determined that an employer is taking a deduction for bonus liabilities in an improper tax year, this can generally be corrected through an accounting method change (i.e., filing a Form 3115, Application for Change in Accounting Method). If the employer is not disqualified by scope limitations under Section 5.01(1) of Rev. Proc. 2015-13, the method change may be made automatically. The scope limitations, which affect whether or when the change can be made automatically, address whether an employer is in its final year of its business and whether it has made a prior method change for bonus liabilities.
If the scope limitations do not apply to the employer, Section 19.01(2) of Rev. Proc. 2015-14 permits a change to either of the following methods: (1) if all the events that fix a liability to pay a bonus occur in the tax year subsequent to the tax year in which the related services are provided, to treat the bonus liability as incurred in such subsequent tax year, or (2) if all the events that fix the liability to pay a bonus have occurred by the end of the tax year in which the related services are provided and the bonus is received by the employee no later than 2½ calendar months after the end of the tax year in which the related services are provided, to treat the bonus liability as incurred in that tax year.
By voluntarily correcting an improper accounting method under Rev. Proc. 2015-13, a taxpayer that is not under IRS examination, and in certain circumstances a taxpayer that is under IRS examination, generally receives audit protection (meaning that the IRS generally may not make an adjustment or method change for bonus liabilities in a tax year prior to the year of change) and will generally be able to spread the income pickup required by Sec. 481(a) ratably over four tax years, beginning in the tax year of change. Automatic method changes generally may be filed by the time the taxpayer timely files (including extensions) its tax return for the year of change. Therefore, calendar-year employers that fully extend their returns may have until Sept. 15 of the following year to submit the required Form 3115.
If an employer does not voluntarily correct an improper accounting method for bonuses, the IRS may make an adjustment or method change for the bonus liabilities for any open tax years and may require the employer to recognize the income pickup required by Sec. 481(a) entirely in the year the method change is made. Additionally, employers that are subject to method changes as part of an exam are not protected from interest and penalty charges on the improper treatment.Potential Implications
It would appear, based on various court holdings and the IRS's discussion in revenue rulings and other guidance, that the IRS is likely to take the position that an employer's retention of discretion until after the close of the service year to alter whether it will pay bonuses to its employees and the bonuses' total amount will keep the liability from fixing until that contingency (board approval, payment, etc.) is eliminated. Whether the terms of the employer's current bonus plan run afoul of the IRS's interpretation of the law is highly factual and requires considering all of the relevant facts and circumstances.
If, after carefully reviewing its bonus plans, however, an employer determines that it has not been accounting for its bonus payments properly, the employer will need to carefully consider its options for correcting any identified issues. These options may include changing the terms of the bonus plan, retaining the plan as is but changing the accounting method for it for current and future years, or some combination of the two. Bonus plans commonly contain provisions granting the employer a certain amount of discretion in determining for nontax reasons whether and how much to pay out in bonuses. As such, any employer that currently deducts bonus liabilities in the year the related services are performed may benefit from reviewing its bonus plans with its tax advisers to determine whether the current tax treatment is appropriate and to consider the various steps that may be need to be taken in light of that review.
This article represents the views of the authors only, and does not necessarily represent the views or professional advice of KPMG LLP or McGladrey LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
1 A discussion of bonuses subject to the deferred compensation rules (when payments are made more than 2½ months after year end) is beyond the scope of this article. Additionally, for purposes of this article, the services provided by the employees are assumed to be the normal services provided in the course of their employment during the tax year and are not services tied to specific contracts or projects that must be completed before an employee is entitled to a bonus.
2 For purposes of this article, it is assumed that taxpayers are using a calendar-year tax year. However, the rules and analysis also apply to taxpayers using fiscal tax years.
3 For instance, specific circumstances may require that some portion of the bonuses be capitalized rather than deducted (e.g., using the uniform capitalization rules under Sec. 263A). These issues are beyond the scope of this article.
4 Sec. 461(a).
5 Regs. Sec. 1.461-1(a)(2)(ii).
6 Sec. 461(h)(2)(A)(i) and Regs. Sec. 1.461-4(d)(2)(i).
7 As discussed above, this article assumes that bonus compensation payments are made within 2½ months after the end of the employer's tax year in which the related services were performed. A payment made more than 2½ months after year end is considered deferred compensation that is generally subject to different rules regarding the timing of taking such liabilities into account for federal income tax purposes.
8 Rev. Rul. 80-230.
9 General Dynamics Corp., 481 U.S. 239 (1987).
10 Id. at 243, citing Lucas v. American Code Co., 280 U.S. 445, 452 (1930), and Security Flour Mills Co., 321 U.S. 281, 284 (1944).
11 Bennett Paper Corp., 78 T.C. 458 (1982).
12 The Washington Post Co., 405 F.2d 1279 (Ct. Cl. 1969).
13 See also Hughes Properties, Inc., 476 U.S. 593 (1986).
14 Rev. Rul. 76-345, emphasis added.
15 Rev. Rul. 2011-29.
16 Bauer Bros. Co., 46 F.2d 874 (6th Cir. 1931).
17 Id. at 876.
18 Willoughby Camera Stores, 125 F.2d 607 (2d Cir. 1942).
19 Field Attorney Advice 20134301F.
20 Sec. 162(m) bonus plans present different considerations, a discussion of which is beyond the scope of this article.
|Kate Abdoo is a tax manager in the Washington National Tax office of McGladrey LLP focusing on accounting methods and periods and is a member of the AICPA Tax Methods & Periods Technical Resource Panel. Karen Messner is a tax senior manager in the Washington National Tax office of KPMG. For more information about this column, contact Ms. Abdoo at email@example.com.|