Bonuses are a key component of compensation packages in the banking industry. In many cases, these bonuses are paid after the year in which the related services were provided, but accrual-basis taxpayers generally want to take the deduction in the same year services were provided. The IRS has increased scrutiny, through the issuance of written guidance and rulings, on the deductibility of bonuses accrued at year-end.
Following are some of the key provisions — and exceptions — related to accrued bonus tax deductions.
General rules of deductibility
In order for a compensation accrual to be deductible in the calendar year the accrual is recorded, the compensation accrual must be established in accordance with guidance set forth by the IRS. The Internal Revenue Code (Sec. 461) allows accrual-basis taxpayers to deduct accrued bonuses, excluding the exceptions mentioned below, if the following four conditions are met:
- All events have occurred to establish the fact of the liability.
- The amount of the liability can be determined with reasonable accuracy.
- Economic performance has occurred with respect to the liability, meaning the employee has already provided the services for the accrued compensation.
- The bonuses will be paid within two-and-a-half months from the end of the calendar year.
The IRS has increased scrutiny, through the issuance of written guidance or rulings, on the deductibility of bonuses accrued at year end.
Other unique accrual issues
Each bonus plan is unique and requires a close application of the rules above to determine whether a deduction can be taken based on the accrual, rather than when the bonus is actually paid. However, there are common provisions in many bonus plans that require special attention:
- Reversion feature — When a bonus plan contains a provision that requires employees to forfeit their bonus if they aren't employed on the date the bonus is paid, and such forfeited amount reverts to the employer (referred to as a “reversion feature”), then the deduction cannot be taken based on the bonus accrual. If this is the case, the deduction would be taken in the year the bonus is paid.
- Bonus pools — Some bonus plans require the employer to establish a pool of bonuses that will be allocated to individual employees. For example, a pool may consist of five percent of net income, and that pool will be allocated to employees based on management’s discretion after year-end.
Historically, the IRS has held that this type of liability isn't fixed at year-end, because the amount of bonus allocable to each employee wasn't fixed at year-end. (Even though the “group liability” was fixed, liability wasn't established with respect to each employee individually.) But the IRS has recently changed its interpretation, and now taxpayers can take the deduction based on the accrual as long as the bonus pool is fixed at year-end based on all other applicable requirements. Note that taxpayers with pooled bonuses still must give consideration to the reversion feature rules discussed further above.
- Employee performance bonuses – If a bonus plan allows employees to receive bonuses on a sliding scale based on performance, companies should take care to ensure that the amount of the bonus is both fixed and determinable by year-end.
Each bonus plan is unique and requires a close application of the rules to determine whether a deduction can be taken based on the accrual.
Exceptions to deductible compensation accruals
Three exceptions preclude companies from taking a tax deduction based on compensation accruals, even if they meet the criteria established above, including:
- C corporation owners (more than 50 percent): Any accrued bonus related to a C corporation shareholder who owns greater than 50 percent of the stock won't be deductible until the bonus is actually paid.
- S corporation shareholders (regardless of percentage owned): Any accrued bonus related to an S corporation shareholder won't be deductible until the bonus is actually paid.
- Certain related parties: Attribution rules apply, so it's possible for several members of a family to be considered owners of a business even if some family members aren't direct owners. These rules are intended to prevent deductions even if all other applicable rules are satisfied.
Taxpayers not recognizing the tax deduction for accrued bonuses in the proper year based on the IRS guidance above would have tax liability exposure. As the 2017 year comes to a close, employers should evaluate their bonus plans to determine if all necessary provisions are in place to make sure the timing of the deduction is being handled appropriately for tax purposes.
The rules can be complex, so please contact us if you have any questions.