Another year is drawing to an end and one item on employers’ to-do lists is calculating year-end bonus payments for key employees and personnel. Determining which year the payment is deductible for tax purposes is an area the IRS has been examining more frequently over the past few years.
There are a variety of factors that need to be considered when determining the timing for when a bonus payment is deductible for tax purposes. Generally, an accrual method taxpayer accounts for a liability for income tax purposes using a three-pronged test:
- All events have occurred to establish the fact of the liability,
- The amount of the liability can be determined with reasonable accuracy, and
- Economic performance has occurred for the liability
All three criteria need to be met in order to deduct the accrued bonus liability in the preceding year of payment.
When using this test, the biggest hurdle to overcome is proving that the liability has been fixed in order to recognize the deduction for tax purposes. The general rule for determining this is to look at both when the event fixing the liability occurs and when payment is due, and then selecting the earlier of these events. The IRS will look at whether or not there is an uncertainty if the bonus will be paid. For example, if an employer’s bonus plan calls for an employee to be employed on the date of the bonus payment, that plan should include a statement that the bonus payment would revert to a pool to be shared with all eligible employees if the employee leaves the company prior to the date of payment. If an employer has any ability to not pay out all or some of the planned bonus payments, the liability will not be considered fixed and the deduction will be denied in the succeeding year.
To establish that the bonus amount is reasonably determinable by year-end, an employer should use a formula that is fixed by the end of the tax year or through an action of the company specifying the amounts by year-end.
Economic performance related to bonus payments typically occurs by year’s end. The employee provides services during the year which has given rise to the bonus payment and created the liability for the employer, thus satisfying economic performance.
If the above tests are satisfied and the bonus payment is made within two and a half months of the end of the employer’s tax year, then the compensation payments are deducted in the year the services are performed. Employers should keep in mind that any S Corporation shareholder owning 2 percent or more of the company can only take a deduction for accrued bonuses in the year of payment, regardless of whether the payment was made within the two and a half months.
As 2016 comes to a close, employers should re-evaluate their bonus plans to determine if all of the necessary provisions are in place to make sure the timing of the deduction is being handled appropriately for tax purposes. The rules can be a bit complex, so please contact us if you have any questions or would like to talk about your company’s individual circumstances.
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