Many employers have formalized annual bonus programs for key employees; these arrangements typically award a bonus if employees reach specific targets. As employers cannot always determine if the targets have been met until after the year is over, it is common for an accrual basis employer to pay a bonus to an employee after year-end.
Employers can pay the bonus after year-end and still deduct it on the prior year’s tax return if the program satisfies all three requirements of the “all events test” contained in Treas. Reg. 1.461-1(a)(2)(i), which are:
- All events have occurred that establish the employer’s liability to make the payment;
- The amount of the payment can be determined with reasonable accuracy; and
- Economic performance has occurred.
Is the IRS rethinking its position?
In a recent IRS Field Attorney Advice (FAA 20134301F), the IRS takes the position that an accrual basis taxpayer cannot deduct these payments in the year before payment if the employer has the right to make certain decisions about the bonus after year-end; the IRS feels that having the right to make these decisions will violate the first two requirements of the “all events test” discussed above. The plans examined by the IRS in the FAA gave the employer too much flexibility, providing: the unilateral right to cancel or modify the bonuses at any time before payment; discretion not to pay executives who were not employed at the payment date; the requirement that a committee approve the payments; and, the ability to base bonuses on a performance appraisal (as opposed to a fixed financial target). Any of those actions could occur in the time period between the year-end and the payment date. As a result of this flexibility, the FAA concluded that the bonuses were deductible in the year of payment.
If the IRS determines that the “all events test” is not satisfied, the employer’s deduction is deferred until the year of payment; it does not mean that the deduction is disallowed—only delayed one year.
What, if anything, should an employer do?
An FAA does not have any precedential value in court, but does give insight into the IRS’ current position. I am a firm believer in formalized annual incentive programs for executives. To the extent possible, these programs should be drafted in a way that allows the bonus to be determined before year end—such as basing results on the first 11 months of the year, or specifically identifying statistical variables before year end. If the bonus program needs board approval, schedule a board meeting before year end to finalize the action. Do not give the employer discretion to change the bonus program for the year—this serves to demotivate employees. Many agreements require that the recipient be employed on the payment date. If an executive received an unwarranted payment in the current year due to the post-year end analysis, perhaps a provision can be included in the incentive plan for the subsequent year that can help the employer recoup some of those funds.
We would be pleased to discuss issues related to executive compensation issues, including bonus plans. For more information on this topic, post a comment below or contact our Compensation & Benefits Advisory Services Group at 440-449-6800.
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