November 15, 2011
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Internal Revenue Code (IRC) S. 461 governs the timing of deduction for certain expenses incurred by accrual method taxpayers. A common expense for which many companies provide an accrual is incentive compensation. The IRS released Revenue Ruling 2011-29 on November 9, 2011, providing guidance on how a plan should be structured in order to permit a deduction in the year the services are provided.
S. 461 and its associated regulations require the following tests be considered in order to determine the timing of a deduction:
- All events must have occurred to establish the fact of the liability,
- The amount of the liability must be able to be determined with reasonable accuracy
- Economic performance must occur for the liability.
The economic performance rule as it relates to deductions for bonus payments, as defined in IRC S. 404, is straightforward. Regulations S.1.404(b)-1T prescribes that economic performance is deemed to occur in the current taxable year as long as payment is made by the 15th day of the 3rd month following such taxable year.
The New Ruling
The first test, in which all events must have occurred to establish the fact of the liability, is the focus of Rev. Rul. 2011-29. This has been a topic scrutinized in various court cases and previous Internal Revenue Service (IRS) rulings. The Washington Post Co. v. United States case allowed deduction of a bonus accrual even when the employer provided a general bonus accrual at the end of the year but did not specifically identify the bonus recipient and the amount payable to that particular recipient prior to the end of the taxable year. IRS Rev. Rul. 76-345 stated that the IRS would not follow the holding in that case. This suggested that individual recipients and the amounts payable to such recipient do need to be specifically identified prior to the end of the year in order for the all events test to be met. Rev. Rul. 2011-29 revokes Rev. Rul. 76-345.
The new ruling states that the following facts are now acceptable evidence to prove the all events test has been met in determining the timing of the deduction:
- The taxpayer’s liability to pay a minimum amount of bonuses to a group of eligible employees is fixed as the end of the year in which the services are rendered,
- The taxpayer is obligated under the program to pay the group the minimum amount of bonuses determined by the end of the taxable year, and
- Any bonus allocable to an employee who is not employed on the date on which bonuses are paid is reallocated to other eligible employees.
In order to satisfy the above conditions, the incentive compensation plan should specifically identify which employees are eligible to participate. The plan requirements should be communicated to eligible employees prior to the end of the taxable year. Lastly, the exact amount of the bonuses payable should be determinable through a formula in effect prior to the end of the taxable year. It is advisable that the plan be formally documented. If all the conditions noted further above are met, all events which fix the liability should be deemed to have occurred and the accrual should be determined with reasonable certainty. Provided the economic performance rule is also met, the tax deduction should be permitted in the year the services are provided.
Observation: Changes in a taxpayer’s treatment of bonuses to conform to this ruling constitute a change in accounting method under Revenue Procedure 2011-14. This procedure allows for an automatic accounting method change. An automatic change is permitted to be submitted with the taxpayer’s timely filed tax return, including extensions, and no user fee is required.
A distinction should be noted with respect to bonuses paid to related parties. The related party rules under IRC S. 267 require the matching of income and deductions arising from transactions between related parties. Related parties include individuals owning more than 50% in value of the outstanding stock of the company. The law requires that even if all events have occurred to fix the liability and the economic performance rules are met, the deduction may not be claimed until the year in which the related party recognizes the income. Thus, in the instance of a bonus payment to a greater than 50% shareholder, the amounts will not be deductible by the company until the period in which the income is recognized by the shareholder.