Editor: Jeff Kummer, MBA
On August 7, 2007, Treasury issued final corporate estimated tax regulations under Sec. 6655, effective for tax years beginning after September 6, 2007 (TD 9347). These final regulations significantly modify the prior proposed regulations (REG-107722-00) and establish a comprehensive set of rules for corporations using the annualized income installment method. Although the annualization method is intended as a safe harbor for computing quarterly installments, in practice the new regulations leave some questions unanswered, casting uncertainty on how “safe” the safe harbor is. Ambiguities in the final regulations will require practitioners to work closely with their clients to develop supportable positions for estimated tax returns computed under the annualized income installment method. An example of this ambiguity is provided below in the context of accounting for bonus compensation deductions.
Special Rule: Reasonably Accurate Allocations
The final regulations contain several special rules that apply to specific deductions that Treasury and the IRS believed could result in significant distortions in the estimate of annualized taxable income. One of these special rules is provided in Regs. Sec. 1.6655-2(f)(2). This rule requires that specific items of deduction that are routinely incurred on an annual basis, or for which a special exception to general accounting rules exists, must be allocated throughout the tax year in a “reasonably accurate manner,” regardless of the annualization period paid or incurred or otherwise properly taken into account. The items of deduction identified for this special treatment are:
- Real property taxes;
- Employee and independent contractor bonus compensation, including the employer’s share of related employment taxes;
- Deductions under Sec. 404 (deferred compensation) and contributions to welfare benefit funds under Sec. 419 (i.e., VEBA contributions);
- Items allowed as a deduction for the tax year by reason of (1) Sec. 170(a)(2) and Regs. Sec. 1.170A-11(b)(certain accrued charitable contributions), (2) Regs. Sec. 1.461-5 (recurring-item exception), or (3) Regs. Sec. 1.263(a)-4(f) (12-month rule); and
- Other deductions designated by Treasury in future guidance.
The regulations define “reasonably accurate manner” as “allocated ratablythroughout the taxable year.” Alternatively, a nonratable allocation will be considered to be made in a reasonably accurate manner if it provides a reasonably accurate estimate of taxable income for the tax year based on the facts known at the end of the annualization period. Regs. Sec. 1.6655-2(f)(2)(iii)(A) provides the following nonexclusive list of relevant factors to consider in evaluating allocations:
- The extent to which the allocation is consistent with nontax books and records accounting for the item;
- The extent to which the allocable portion of the item becomesfixed and determinableduring the applicable annualization period; and
- The extent to which the allocation, if compared with a ratable allocation of the item, results in a better matching of the item to revenue, earnings, the use of property, or the provision of services occurring during the annualization period.
The regulations provide examples of nonratable allocations of bonus compensation that satisfy the relevant considerations. However, none of the examples addresses common scenarios involving bonus liabilities accrued for book purposes in a tax year preceding deductibility because either the all-events test is not met or the bonus compensation is paid later than 2½ months after the tax year of book accrual. In these cases, practitioners must evaluate the propriety of nonratable allocations for which few or none of the considerations enumerated in the regulations are relevant. The following examples illustrate the difficulty taxpayers may encounter supporting nonratable allocations when the current-year bonus deduction relates to book accruals in a prior tax year.
Example 1—bonus accrual fixed by year end and paid within 2½ months: XYZ Corp. is a calendar-year, accrual-basis taxpayer that uses the 3/3/6/9 annualization periods to compute its annualized income installments. XYZ has adopted a plan under which it pays an annual bonus to its employees equal to 2% of earnings. XYZ accrues for this amount and reports the liability each quarter in its nontax books and records. XYZ’s quarterly earnings throughout the 2008 tax year are $10 million, $6 million, $7 million, and $7 million, respectively. On December 31, 2008, XYZ declares a $600,000 bonus to its employees that is paid out on Jan-uary 15, 2009, and is properly deducted in XYZ’s 2008 tax year.
The special rule under Regs. Sec. 1.6655-2(f)(2) requires the bonus compensation deduction allowed for the tax year to be allocated in a reasonably accurate manner. XYZ could allocate the deduction ratably throughout the year, yielding a $150,000 deduction for the annualization period ended March 31, 2008. Alternatively, based on its earnings results and other information available as of March 31, 2008, XYZ could allocate $200,000 ($10 million × 2%) to the first quarter because the allocation represents a better matching of the bonus compensation to earnings in the quarter than a ratable accrual allocation and is consistent with the allocation provided in XYZ’s nontax books and records.
Example 2—bonus plan that fails the all-events test in year of book accrual: Assume the same facts as Example 1, except that the plan contains additional terms that prevent the $600,000 accrued bonus from fixing prior to payment on January 15, 2009. Therefore, the $600,000 bonus payment is not deductible until the tax year ended December 31, 2009.
XYZ could allocate the deduction ratably throughout the year, yielding a $150,000 deduction for the annualization period ending March 31, 2009. Alternatively, XYZ may evaluate whether it can reasonably allocate the entire $600,000 bonus deduction to the annualization period ending March 31, 2009. This specific allocation would satisfy the second consideration provided in Regs. Sec. 1.6655-2(f)(2)(iii)(A): The item becomes fixed and determinable during the annualization period when payment is made. How-ever, the taxpayer must weigh other considerations as well, including the caution in Regs. Sec. 1.6655-2(f)(2)(iii)(B) that the “fact that a liability for an annual expense becomes fixed and determinable during an annualization period will not establish that allocating all of the expense to that annualization period has been done in a reasonably accurate manner if the facts known as of the end of the annualization period indicate otherwise.”
Example 3—bonus plan deferring receipt of compensation (not paid within 2½ months):Assume the same facts as Example 1, except that the bonus is not paid until March 31, 2009. Because the payment is made more than 2½ months after year end, the plan defers the receipt of compensation, and the bonuses are not deductible until paid under Sec. 404.
Under these facts, none of the considerations enumerated in Regs. Sec. 1.6655-2(f)(2)(iii)(A) is relevant to the bonus compensation: (1) Given the inherent difference between generally accepted accounting principles (GAAP) and Sec. 404, the allocation of a Sec. 404 deduction throughout the year (ratable or otherwise) can never be consistent with GAAP; (2) the liability’s entire amount was fixed and determinable prior to any of the annualization periods in the current estimated tax year; and (3) the requisite services related to the liability occurred before (not during) any annualization period in the estimated tax year.
Because the list of considerations provided in the regulations is not exclusive, taxpayers may consider other factors to determine if a nonratable allocation provides a reasonably accurate estimate of taxable income. In the preamble to the regulations, Treasury and the Service acknowledge that various allocations may be considered to be done in a reasonably accurate manner and that taxpayers should have flexibility in determining which allocation to use, particularly when use of a specific allocation reduces administrative burdens. However, allocations that are made with the intent to distort will not be considered to have been made in a reasonably accurate manner.
The new estimated tax regulations made significant changes to the rules that most corporations have been following for over 23 years. The bonus compensation discussion above illustrates only one application of the new regulations to a specific item of deduction governed by a special rule. The regulations provide for several additional special rules as well as a revamped general rule, each differing to some degree from the rules taxpayers previously relied on. Therefore, corporations should modify their existing computation methodologies before their 2008 quarterly estimates become due (April 15, 2008, for calendar-year corporations).
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 firstname.lastname@example.org.
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.