Are you able to accrue and deduct annual bonuses for a 2013 calendar year performance period in 2013, so long as you pay the bonuses to your employees by March 15, 2014? If this question sounds familiar, it is because we have blogged about past efforts of the IRS to address this issue. Historically, most employers believed that the answer was they could deduct the bonuses in the year accrued rather than the year paid, but during the past few years, the IRS has chipped away at that belief. In a recent Chief Counsel Advice Memorandum, the IRS issued its most sweeping guidance to date on the issue. See Chief Counsel Advice Memorandum 20134301F (the “2013 Memo”). (The weight of this memorandum as IRS guidance is unclear, particularly since the link to the guidance no longer works and we can no longer find the memorandum with a website search. We hope that the IRS will clarify its position soon, as these issues potentially impact many employers.) Under the 2013 Memo, if an employer waits until 2014 to certify that the 2013 performance goals were achieved, or if it has discretion to reduce or eliminate the amount of the bonus payable, the employer must wait until 2014 to deduct the amount of the bonus payments. Further, if the bonus is conditioned in part on a subjective employee evaluation that does not take place until 2014, the employer may not deduct the bonus payments until 2014. In short, the 2013 Memo requires that in most cases, an employer must deduct the bonus in the year the bonus is paid rather than the year accrued.
The 2013 Memo could have an especially big impact on public company employers because the circumstances described in the 2013 Memo are similar to how public company employers try to satisfy the performance-based compensation requirements of Code Section 162(m). Many other employers follow similar practices with respect to their bonus plans as well. As such, all employers who sponsor annual bonus plans need to understand the latest changes from the IRS to determine which year is the appropriate year to deduct the amount of their bonus payments. Beyond the timing of the deduction, there are also several tax compliance and financial reporting facets related to this issue. The impact on deferred tax assets, reporting for uncertain tax positions, and the potential need to apply for an accounting method change with the IRS all need to be examined by employers sponsoring annual bonus plans.
“All Events” Test for Deductibility
The issue centers around the “all events” test described in the regulations under Code Section 461. These regulations 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. The 2013 Memo analyzes the following types of bonus arrangements and concludes that in each case, the first two prongs of the all events test described above will not be satisfied:
- If the taxpayer retains the right to modify or eliminate the bonuses, the bonuses paid under the plans do not meet the all events test before than the date the bonuses are paid.
- If bonuses under certain plans are subject to committee or board certification or approval, the bonuses paid under these plans do not meet the all events test before the date the bonuses are ratified or approved by the board committee.
- If subjective determinations must be made to calculate the amounts of employee bonuses (e.g., a part of the bonus is based on a numeric score from a subjective performance review), the bonuses paid under these plans do not meet the all events test before the date the employee performance appraisals are completed.
The 2013 Memo adds that these conclusions still apply even in the following cases:
- The employer’s compensation committee approved, in the first quarter of the performance year, objective performance criteria to be used for calculating the bonuses.
- The bonuses were paid no later than the 15th day of the 3rd month after the end of the taxable year.
- The employee needed to be employed only on the last day of the performance period and not the date of payment.
Impact on Employers
All of these scenarios are common bonus plan practices, especially for publicly traded employers who have designed their plans to qualify as performance-based compensation under Code Section 162(m). Although the IRS did not address Code Section 162(m) in the 2013 Memo, it almost appears as though the IRS is forcing publicly traded employers to use the cash basis of accounting for purposes of annual bonus plans. That is evident when reading how the IRS distinguished the 2013 Memo from Revenue Ruling 2011-29 (the “2011 Ruling“). In the 2011 Ruling, the IRS held that when an employer committed in the year of accrual to paying an aggregate bonus pool amount, the employer could deduct the bonuses in the year accrued instead of the year paid. That would be the case even if the identity of the employees receiving the bonuses, and the amounts of those bonuses, were not yet known because the aggregate amount paid would remain constant. The Code Section 162(m) regulations, however, prohibit this practice for public company employers, at least to the extent that they want to deduct compensation payable to covered employees that exceed $1 million. The practical effect then, is that employers who design and administer their annual bonus plans in a manner consistent with the performance-based compensation requirements of Code Section 162(m) typically will be required to deduct their bonus payments in the year they were paid, rather than accrued.
The IRS’s reasoning for this result is rather straightforward—if an employee evaluation or committee certification does not occur until after the end of the performance period, “all events” with respect to the bonus are not completed until the year of payment. Further, whenever an employer retains discretion to amend or eliminate the amount of the bonus, no legally binding right to the bonus has been created. This argument is interesting because the Code Section 409A regulations have a similar concept. Specifically, if an arrangement does not provide a legally binding right to payment, then the arrangement cannot be considered deferred compensation subject to Code Section 409A. These regulations include a caveat, however, that states that if there is a pattern or practice of always paying an amount, that pattern or practice could indicate that there is a legally binding right after all. The 2013 Memo did not mention the Code Section 409A regulations, but the facts suggested that the employer had a consistent practice of paying bonuses each year, and yet, the IRS still held that did not provide a legally binding right to payment. Could this determination mean that more arrangements than previously thought do not provide a legally binding right to compensation, and thus are exempt from Code Section 409A? We’ll let the IRS address that question at a later date.
Considerations for Compliance and Financial Reporting
We asked our friend Chris Dean, a CPA and Tax Senior Manager at GBQ Partners LLC, to explain the considerations for compliance and financial reporting. His explanation follows. (Thanks Chris!).
Certain positions taken on a federal income tax return constitute a method of accounting in respect to the item. The significance of reaching this threshold is that a change of the method (even if it is changing from an “unpermitted” to a “permitted” method) needs to be disclosed with the IRS. This disclosure is actually an application whereby the taxpayer requests the permission of the IRS to change its accounting method with respect to the item. Further, certain accounting method changes constitute “automatic” changes that may be submitted along with a timely filed return. Other changes that are not “automatic” generally need to be applied for separately during the tax year for which the change is requested and are accompanied by a filing fee. Employers and their tax advisors will need to carefully consider the tax accounting method treatment of accrued bonuses and then determine if, and when, the appropriate disclosures and applications for change need to be filed.
Financial reporting can also be impacted by the tax treatment of accrued bonuses. Under GAAP, corporate employers are required to report temporary differences for tax purposes under the Asset and Liability Method. Essentially, a corporate employer that reports a current book expense for accrued bonuses, but cannot deduct those bonuses for tax purposes until they are paid, will need to reflect the eventual future tax benefit of those deductions as a deferred tax asset on its balance sheet at year end. The corporate employer will also need to reflect a current liability for the tax effect of not being able to deduct the bonuses on this year’s return. Further, GAAP also has standards requiring the accounting for uncertain tax positions. Even if a corporate employer continues to deduct bonuses in the year accrued instead of the year paid, it may be necessary to reflect a tax reserve in the form of a liability on its balance sheet. If it is determined that the position taken on the tax return does not meet a “more likely than not” standard for being upheld upon examination by the IRS, the corporate employer will need to reflect a liability for the amount of tax (and the associated penalties and interest) that would be due if the bonus deduction were to be adjusted by the IRS. As with tax compliance, employers and their advisors need to consider the impact accruing bonuses will have on financial reporting.
For now, the key takeaway for employers is that the IRS has limited (if not eliminated) the ability to deduct bonus payments in the year accrued rather than the year paid. Anyone who wishes to deduct their bonus payments in the year accrued should proceed very carefully after consulting with both accounting and legal counsel.