Accelerating deductions will be in the forefront of everyone's mind if there is a reduction in the corporate income tax rate. This discussion focuses on how payroll tax accruals might be deducted in 2017 rather than 2018 without additional costs or administrative burdens for the employer and no adverse tax consequences for the employees, resulting in a permanent tax savings to your client.
Payroll taxes are deducted as trade or business expenses under Sec. 162, treated as passive expenses under Sec. 469, or capitalized under the UNICAP rules of Sec. 263A. Historically, the IRS's position was that Federal Insurance Contributions Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes for accrual-method taxpayers were deducted only in the tax year the compensation giving rise to the payroll tax liability was paid (Rev. Rul. 69-587 (bonus and vacation pay); Rev. Rul. 74-70 (wages accrued but unpaid at year end)).
This position was challenged in Eastman Kodak Co., 534 F.2d 252 (Ct. Cl. 1976). The court held, contrary to Rev. Rul. 74-70, that payroll taxes on wages earned and properly accrued in the last week of 1964 but paid in the first week of 1965 (year-end wages) were deductible under the all-events test in 1964 because the obligation to pay taxes on the year-end wages became fixed and certain as an automatic consequence of the definite obligation to pay the earned wages.
The issue of payroll tax accrual on vacation pay vested but unpaid at year end and bonus pay also vested at the end of 1964 but not payable until March 1965 was also addressed. Although the obligation to pay these expenses was established, the tax liability was not as certain, since at year end, it would not be clear that the FICA and FUTA wage ceilings would be reached when it came time to remit the compensation. The payroll tax wage ceilings were low in 1965, i.e., $4,800 for FICA and $3,000 for FUTA. An individual employee's wages in the first quarter of 1965 could meet the FICA ceiling prior to his or her receipt of the bonus (which had accrued in 1964), resulting in no payroll tax liability for the bonus payment. Similarly, for vacation pay, it would be difficult to demonstrate that the employer knew at the end of 1964 whether the employee would take vacation and receive the pay before or after the individual employee's salary hit the FICA wage limit in 1965. As a result, the all-events test was not satisfied for the payroll taxes on the vacation and bonus pay for the tax year in which the compensation was earned.
Although the IRS initially disagreed with the decision in Eastman Kodak, it conceded the issue of deductibility of year-end wages in Rev. Rul. 96-51, which provides that an accrual-method employer may deduct payroll taxes imposed on year-end wages that are properly accrued in one year but are paid in the next year, if the employer satisfies the requirements of the recurring-item exception to the economic performance rules with respect to those taxes.
Under the recurring-item exception (Regs. Sec. 1.461-5), a liability is treated as incurred for a tax year if (1) at the end of the tax year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (2) economic performance occurs on or before the earlier of (a) the date that the taxpayer timely files a return (including extensions), or (b) the 15th day of the ninth calendar month after the close of the tax year; (3) the liability is recurring in nature; and (4) either the amount of the liability is not material or accrual of the liability in the earlier year results in a better matching of the liability against the income to which it relates.
For taxpayers wanting to take advantage of this method of accounting for the accrued payroll tax on wages, an automatic change is available under Section 19.04(1)(a)(i)(A) of Rev. Proc. 2017-30. Accounting method change No. 45 pertains to payroll tax liabilities where the underlying compensation is wages paid within 2½ months of year end, and thus is not considered deferred compensation under Sec. 404 and Temp. Regs. Sec. 1.404(b)-1T. In Rev. Rul. 96-51, the year-end wages were paid before the 15th day of the third calendar month after the end of year 1, and the revenue ruling's application to deferred compensation was not discussed.
That question of whether an accrual-method taxpayer could deduct its payroll tax liability incurred in year 1 if it relates to deferred compensation not deductible until year 2 was posed in Rev. Rul. 2007-12. The IRS concluded that payroll tax liability does not represent compensation paid or accrued by an employer on account of any employee. Consequently, even if the payroll tax liability relates to deferred compensation, Sec. 404 does not control the deductibility of the employer's liability for payroll taxes. If the all-events test and the recurring-item exception are otherwise satisfied, the accrual-basis taxpayer may treat its payroll tax liability as incurred in year 1, regardless of the fact that the deferred compensation to which the liability relates is not deductible until year 2.
However, for both current and deferred compensation, there is the issue of satisfying the all-events test and the recurring-item exception with regard to the underlying payroll tax liability. As a practical matter, it can be difficult for a taxpayer to satisfy Regs. Sec. 1.461-5(b)(1)(i), i.e., to assert that, at the end of year 1, the corresponding payroll tax liability was established and the amount could be determined. At year end, it could be problematic to determine whether, with a particular employee, the applicable payroll tax ceiling (or at least the FICA ceiling) would be reached. For the taxpayers' convenience, and only for purposes of meeting this requirement of the recurring-item exception, the IRS provides a safe harbor.
Rev. Proc. 2008-25, the IRS created a safe-harbor method of accounting for accrued payroll tax liabilities on bonus and vacation pay and provides a procedure to obtain the IRS's automatic consent to change to the safe-harbor method. For these purposes, a taxpayer is treated as meeting the requirement in Regs. Sec. 1.461-5(b)(1)(i) for its payroll tax liability in the same tax year in which all events have occurred to establish the fact of the related compensation liability, and the amount of the related compensation liability can be determined with reasonable accuracy. Section 19.04(1)(a)(iii) of Rev. Proc. 2017-30 allows for automatic consent to change to this method of accounting (accounting method change No. 113).
Two examples are provided in Rev. Proc. 2008-25. The first involves vacation pay as the deferred compensation:
Example 1: X uses an accrual method of accounting, including the use of the recurring-item exception, and files its returns on a calendar-year basis. X properly changes to the safe-harbor method of accounting described in Rev. Proc. 2008-25 for its payroll tax liabilities. During year 1, A, an employee of X, earns $10,000 of vested vacation compensation for services performed during year 1. X pays the vacation compensation to A in February and May of year 2. X incurs a payroll tax liability for the $10,000 vested vacation compensation payment. Assume that, as of Dec. 31 of year 1, all events have occurred to establish the fact of X's vested vacation compensation liability, and the amount of the liability is determinable with reasonable accuracy. Under the provisions of Rev. Proc. 2008-25, and solely for purposes of applying the recurring-item exception, all events necessary to establish the fact of X's payroll tax liability for the $10,000 vested vacation compensation will be treated as having occurred in year 1, and the amount of the payroll tax liability will be treated as being determined with reasonable accuracy in year 1.
The second example involves the payment of incentive compensation:
Example 2: Y uses an accrual method of accounting, including the use of the recurring-item exception, and files its returns on a calendar-year basis. Y properly changes to the safe-harbor method of accounting described in Rev. Proc. 2008-25 for its payroll tax liabilities. On Dec. 28 of year 1, Y 's board of directors approves a bonus pool of $1 million to be paid to Y 's employees for services provided during year 1. The $1 million in bonuses is paid to Y 's employees on Jan. 5 of year 2. Y incurs a payroll tax liability as a result of the $1 million in bonuses paid to its employees. Assume that, as of Dec. 31 of year 1, all events have occurred to establish the fact of the bonus compensation liability, and the amount of the liability is determinable with reasonable accuracy. Under the provisions of Rev. Proc. 2008-25, and solely for purposes of applying the recurring-item exception, all events necessary to establish the fact of Y 's payroll tax liability for the $1 million in bonuses will be treated as having occurred in year 1, and the amount of the payroll tax liability will be treated as being determined with reasonable accuracy in year 1.
As part of the changes described above, a taxpayer that previously has not changed to or adopted the recurring-item exception for FICA, FUTA, or state unemployment taxes must change to the recurring-item exception method for such taxes (Rev. Proc. 2017-30, §19.04(2)). A taxpayer using the accrual method of accounting is allowed to adopt the recurring-item exception simply by accounting for the item on a timely filed original return for the first tax year in which that type of item is incurred (Regs. Sec. 1.461-5(d)).
A recent Tax Court decision, Petersen, 148 T.C. No. 22 (2017), involving accrued compensation liability as well as related payroll items, posed the question whether employee participants in an employee stock ownership plan (ESOP) that owned shares in an S corporation were considered related to the S corporation for this purpose. The employees did not own shares in the S corporation directly. The court held that the participants in the ESOP were related persons to the S corporation for purposes of the deduction deferral rules of Sec. 267(a)(2). S corporations with an ESOP owner should be mindful of reviewing year-end accruals for any amounts payable to the ESOP participants.
Lastly, a cash-basis taxpayer cannot use the recurring-item exception and is therefore only able to deduct FICA, FUTA, and state unemployment taxes in the year paid.
EditorNotes
Mark Heroux is a principal with the National Tax Services Group at Baker Tilly Virchow Krause LLP in Chicago.
For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.
Unless otherwise noted, contributors are members of or associated with Baker Tilly Virchow Krause LLP.
