Are you able to accrue and deduct annual bonuses for a 2011 performance period in 2011, despite the fact that an employee is required to be employed through the payment date in 2012 in order to receive the bonus? A few years ago, the IRS issued guidance that strongly suggested the answer was no, the deduction could not be taken in 2011. CCA 200949040 (the “2009 Memorandum“). The 2009 Memorandum caught some employers by surprise because they assumed that under Code Section 461, if they paid bonuses within two and a half months after the end of 2011 (i.e., by March 15, 2012), they could deduct the amounts in 2011.
That was a fairly common belief, despite the fact that the employees would include the payments in taxable income in 2012 (the year they were in actual or constructive receipt of the bonus payments). Recently, however, the IRS appears to have granted some relief from this view in allowing employers to deduct the bonus payments in 2011, provided that certain conditions are met. See Revenue Ruling 2011-29 (the “2011 Ruling“). The relief that the Ruling offers, however, appears somewhat more limited than what many employers may realize.
As background, Treasury Regulations under Internal Revenue Code Section 461 state that under the accrual method of accounting, a liability is incurred and taken into account for tax purposes in the tax year in which (1) all events have occurred that establish the fact of the liability, (2) the amount of the liability can be established with reasonable accuracy, and (3) economic performance has occurred for the liability. Collectively, this is the “all events test.”
The 2011 Ruling addresses prong (1) of the all events test. It states that generally, all events occur to establish the liability when either the event fixing the liability occurs, or payment is unconditionally due. In the 2009 Memorandum, the IRS held that when a plan requires an employee to be continuously employed through the date of payment, all of the events do not occur until the actual payment date. As such, the employer could not deduct the bonus until the year of payment (i.e., 2012).
The 2011 Ruling distinguishes the 2009 Memorandum in a key respect. Under the 2009 Memorandum, if the employee terminated before the bonus payment date, the amount of the bonus that otherwise would have been paid to the employee reverted back to the employer. In the 2011 Ruling, this amount does not revert to the employer, but instead, is reallocated among the remaining employees. As such, the total amount of the bonus remains fixed, even though the identity of the employees receiving the bonus and the amount payable to any individual employee is not known at the end of 2011. Because the total amount payable is fixed at the end of 2011, however, the employer may deduct the bonus in 2011.
Accordingly, employers need to consider the following factors when deciding when to deduct the amount of bonus payments:
- In order to deduct in 2011 a bonus that is paid in 2012, the employer must be on the accrual method of accounting.
- In addition, the amount of the total bonus payable needs to be fixed as of the last day of 2011. To the extent that the total amount is not fixed (e.g., because a forfeited employee bonus reverts to the employer rather than being reallocated among the other employees), the employer must deduct the bonus payments in 2012. As a practical matter, employers may want to accrue an estimated amount that is lower than the amount of the expected bonus. In essence, the employer would determine an amount that it knew would be fixed. It could deduct this amount in 2011. Any amount in excess of this estimate would need to be deducted in 2012.
In essence, the relief provided in the Ruling is not quite as extensive as what employers might have hoped to see. In particular, the requirement that the employer fix in 2011 a minimum amount of bonus that will be paid in 2012 and not revert to the employer may prove to limit the relief somewhat. Nevertheless, the 2011 Ruling still provides tax planning opportunities for employers with respect to their bonus plans.
