Companies often accrue employee bonuses at year end. Several requirements must be satisfied in order to deduct those bonuses in the year the services were rendered (as opposed to the following year when the bonuses are paid). Is your bonus plan structured and administered in such a way to ensure a tax deduction in the earliest possible year? The answer may surprise you.

For taxpayers using the accrual method of accounting, a liability generally is deductible under the "all-events test" in the taxable year in which:

• All events have occurred that establish the fact of the liability
• The amount of the liability can be determined with reasonable accuracy, and
• Economic performance has occurred with respect to the liability.

Economic performance with respect to compensation generally occurs when the services creating the right to the compensation are performed. Compensation paid to an employee more than 2 ½ months after the end of the employer's tax year, however, is not deductible until the year it is paid. Because of this "2 ½ month rule," employers have been lured into a false sense of security, believing that any compensation paid within 2 ½ months of year end for services provided in the prior year were deductible in the year the services were provided.

Through a series of rulings, however, the IRS has emphatically reminded employers that the 2 ½ month rule is not the only hurdle that must be cleared to deduct accrued compensation. The other tenets of the all-events test also must be satisfied. The requirement that the fact of the liability must be established and fixed by year end can prove problematic for employers seeking to deduct accrued bonuses, especially when the employee has to still be employed on the date the bonuses are paid to receive the bonus.

Ruling # 1 – Forfeited Bonuses Revert Back to Taxpayer

In CCA 200949040, the taxpayer paid bonuses to its non-executive employees under a plan that required employees to be employed by the taxpayer on the date that bonuses were paid in order to receive that compensation. Any amounts not paid to employees by virtue of their termination of employment between the end of the year and the date on which the bonuses were paid reverted back to the employer. The IRS reasoned that if the forfeited bonuses revert back to the taxpayer, then the liability for the bonus compensation is subject to a contingency. The liability does not become fixed until the date of payment when the employees actually receive their bonuses. Therefore, the bonuses were deductible in the year in which they were paid, despite the fact that they were paid within 2 ½ months of the employer's year end.

Ruling # 2 – Forfeited Bonuses Allocated to Other Employees

In Rev. Rul. 2011-29, the minimum amount of total bonuses payable to the taxpayer's employees as a group was determinable either through formula or other corporate action before the end of the tax year. As in CCA 200949040, an employee had to be employed on the date the bonuses were paid to receive a bonus. In contrast to CCA 200949040, however, any bonus allocable to an employee who was no longer employed on the date the bonuses were paid was reallocated to other eligible employees. Thus, the aggregate amount of bonuses due under the program was fixed as of the end of the year. Accordingly, bonuses paid within 2 ½ months of the employer's year end were deductible in the year the services were rendered. Rev. Rul. 2011-29 emphasized that the aggregate amount of bonuses was deemed fixed even though the identities of the ultimate recipients and the amount each employee was to receive could not be determined prior to year end.

Ruling # 3 – Bonuses Forfeited After a Certain Date Revert Back to Taxpayer

To illustrate how the minute details of a bonus plan's administration can decide in which year the bonuses are deductible, consider CCA 201246029. Pursuant to a formula based on company performance metrics and the number of eligible employees, an aggregate bonus was accrued at year end. To receive a bonus, employees must remain employed until the bonuses are paid. In February of the following year, the taxpayer's section managers are allotted a bonus pool to allocate among that section's employees. Any employee who had terminated employment between year end and the date on which the section manager allocated the bonus pool forfeited his or her right to a bonus and that bonus would be allocated to remaining employees. Once the section manager finalized the individual bonus awards, however, forfeited amounts (for those employees who terminated employment between the time the section managers made their allocations and the time the bonuses were paid) were not reallocated to the remaining employees; instead, those amounts reverted back to the employer. The bonuses were paid on March 15th.

Because bonuses reverted back to the taxpayer if they were owed to employees who terminated employment between when the section manager finalized the individual bonus awards and when the bonuses were paid, the IRS concluded that the liability for the bonuses was not fixed until the bonuses were paid. Therefore, as in CCA 200949040 (Ruling # 1 above), the bonuses were deductible in the year in which they were paid, again despite the fact that they were paid within 2 ½ months of the employer's year end.

The taxpayer argued that the amount of bonuses that were actually forfeited and that reverted back to the taxpayer was de minimis and, thus, the deduction for the bonuses should be allowed in the year the services were rendered. The IRS rejected this argument, noting that there is no de minimis exception to these rules. In fact, the amount of bonuses that ultimately were forfeited is irrelevant. Simply the fact that a forfeited bonus could revert back to the taxpayer creates the contingency that precludes the deduction in the year the services are rendered.

An Extreme Example

The implications of CCA 201246029 can be illustrated by an extreme example. Assume a calendar year, accrual basis employer has a bonus plan and the following occurs:

• Based on the bonus plan's formula, the company accrues a $300,000 bonus pool as of December 31st.


• To receive a bonus, an employee must still be employed on the date the bonuses are paid – March 15th.


• The company's management team finalizes the allocation of the $300,000 bonus pool on March 12th and turns in those allocations to its payroll service to generate payroll checks for distribution on March 15th.


• Anyone who terminated employment prior to when the management team finalized the bonus allocations on March 12th forfeited his or her bonus and that amount was reallocated to other employees.


• For administrative ease, should anyone terminate employment between March 12th and March 15th, the company would simply stop that employee's payroll check and that bonus amount would essentially revert back to the employer.


• The company does not attempt to reprocess other employees' bonus checks to allocate amounts forfeited between March 12th and March 15th, nor does it allocate the forfeited amounts to other employees in a subsequent payroll.

Based on a strict reading of CCA 201246029, the $300,000 of accrued bonuses were subject to a contingency as of December 31st and therefore would not be deductible until the following year when the bonuses were paid. This would hold true even if no employees terminated employment during those three days between when the bonus amounts were sent to the payroll service and when the payroll was actually paid.

How Do You Ensure That Your Accrued Bonus Liability is Fixed as of Year End?

Assuming that your aggregate accrued bonus is based on a formula or corporate action that is fixed as of year end, there are several ways to structure your bonus program so that you do not run afoul of the fixed liability requirement:

• Option 1: Only require that employees must still be employed on the last day of the taxable year to be eligible for a bonus. Of course, you may require a longer period of employment for valid business reasons so you will need to weigh those reasons against the possibility that your tax deduction will be deferred until the bonuses are paid.


• Option 2: Require that employees must still be employed on the date the bonuses are paid to receive a bonus and stipulate that any forfeited bonuses will be reallocated to other eligible employees, with the following variations:


• Set the cutoff for bonus eligibility at some date prior to when the bonuses are paid so you have adequate time to reallocate any forfeited bonuses to other eligible employees before the bonuses are actually paid (e.g., require employees to still be employed on March 1st instead of March 15th when the bonuses are paid); or


• Stipulate that any bonuses forfeited after allocations to individual employees are finalized, but before bonuses are paid, will be reallocated to other employees in a subsequent payroll. If that subsequent payroll occurs after March 15th (for a calendar year taxpayer), the reallocated bonus will not be deductible until the year in which it was paid, but this amount presumably will be very small relative to the rest of the bonus pool which will still be deductible in the year the services were rendered.

However you decide to structure your bonus program to ensure that your bonus liability is fixed as of the end of the year, be sure those elements are documented in your bonus plan. Remember that the contingency which prevents your bonus liability from being fixed at year end is not dependent on whether an employee actually terminates employment causing the forfeited bonus to revert back to the employer. Merely the possibility that a forfeited bonus could revert back to the employer is enough to create the contingency that prevents the bonus liability from being fixed at year end.

Whether or not the bonus liability is fixed as of year end is not the only issue that can impact the timing or amount of the bonus deduction. Accrued compensation owed to individuals with certain percentages of ownership in the company (and their relatives) is not deductible until the compensation is paid. And of course, all compensation must be considered "reasonable" to be deductible at all. An in depth discussion about related party limitations or reasonable compensation is beyond the scope of this article.

If your company has a bonus plan or accrues any compensation to its employees at year end, consult your local CBIZ MHM tax advisor to discuss the nuances of your plan and whether the requirements for deducting the accrued liability are being satisfied. Minor tweaks to your bonus plan could have a major impact on the timing of your deduction.

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