Establishing the “Fact of the Liability” for Bonus Compensation

Editor: Greg A. Fairbanks, J.D., LL.M.

Expenses & Deductions

A recent IRS legal memorandum (ILM 201246029) serves as a reminder to business taxpayers to consider modifying or updating their employee bonus plans to enable a deduction for bonus compensation accrued in the year of the related services, as provided in Rev. Rul. 2011-29.

In Rev. Rul. 2011-29, X’s bonus program established a minimum total amount of bonuses payable, either through a formula that was fixed prior to the end of the tax year or through other corporate action made by the end of the tax year, such as a resolution of X’s board of directors or compensation committee. To be eligible under the program, employees needed to perform services during the tax year and be employed on the date of the bonus payment. Any bonus amounts allocable to employees who were not employed on the payment date were reallocated to the other eligible employees. Thus, the departure of any employee did not affect the aggregate amount of the bonus payment. X paid the bonuses after the end of the tax year of the related services and before the 15th day of the third calendar month after the close of that year.

Based on these facts, the IRS stated that the fact of X’s liability for the minimum amount of bonuses was established by the end of the year in which the services were rendered. Accordingly, the IRS determined that an employer can thus establish the “fact of the liability” under Sec. 461 for bonuses payable to a group of employees, even though the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the tax year.

In contrast to Rev. Rul. 2011-29, the IRS concluded in ILM 201246029 that a taxpayer must take a liability for bonus compensation into account in the year the bonuses were paid because some unpaid bonuses reverted to the taxpayer if an employee left employment after the bonus was allocated to him or her.

Under its incentive compensation plan (ICP), the taxpayer finalized the aggregate amount of bonuses for book purposes at the end of a plan year based on the number of eligible employees employed on Dec. 31. The taxpayer paid the bonuses by March 15 in the year following the plan year. In January or February of the plan year, the taxpayer determined bonuses in the annual compensation planning process. The aggregate amount of bonuses paid generally did not exceed the amount accrued for book purposes at the end of the plan year. The ICP required all eligible employees to still be employed with the taxpayer when the bonuses were paid to receive their bonus.

In the February after the plan year, the taxpayer’s compensation committee would review and approve the bonuses. Each of the taxpayer’s section managers was allocated a total bonus amount for his or her employees. If any employee left before the manager allocated the bonus amount among the individual section employees, the employee forfeited the right to a bonus, and the total bonus amount was reallocated among the remaining employees. If, however, an eligible employee left after the section manager finalized the individual bonus awards but before the bonuses were paid, the forfeited bonus award was not allocated among the remaining employees; instead, it reverted to the taxpayer.

The taxpayer took the position that the liability for all bonus compensation was deductible in the year of service because the amount of bonuses actually forfeited represented a de minimis portion of the bonuses accrued at year end. The taxpayer based its position on Rev. Rul. 2011-29.

The IRS concluded, however, that the taxpayer’s liability was not fixed in the year of the related services. The IRS noted that once the section manager finalized an individual’s bonus award, it was not reallocated to the remaining employees if that employee left before the bonus was paid, and that such amounts reverted to the taxpayer. The IRS stated that the liability could become fixed only when the contingency (the employee’s still being employed on the date of payment) was satisfied. The IRS also noted that there is no de minimis exception to this rule. Accordingly, the IRS concluded that the taxpayer must take the liability for bonus compensation into account in the year it paid the bonuses.

Based on these authorities, it is the IRS’s position that taxpayers with bonus compensation plans that require an employee to remain employed on the date of the bonus payment and under which forfeited bonus amounts revert to the taxpayer may not deduct bonus accruals in the year of the related service, even if such amounts are paid before the 15th day of the third calendar month after the close of the year. Such taxpayers should consider whether simple changes to their employee bonus plans are desirable and would yield significant tax benefits under the IRS’s position. Taxpayers should examine not only their plan provisions but also their administrative procedures to ensure that all bonuses not paid to departed employees are allocated and paid to other employees by the 15th day of the third calendar month after the close of the year.

EditorNotes

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 greg.fairbanks@us.gt.com.

Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.