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Tuesday, June 18, 2013

Timing of Bonus Compensation Deduction


While it is widely understood that to obtain a tax deduction for a bonus compensation accrual the amount must be paid within two and a half months following the close of the tax year, the requirement that it also be fixed and determinable may not be so clear. Recently, the IRS provided initial guidance in Rev. Rul. 2011-29 regarding when the liability is deemed fixed and determinable and has subsequently clarified its position in a recent legal memorandum (ILM 201246029).

In ILM 201246029, the IRS concluded that a liability for bonus compensation is taken into account in the year in which the bonus was paid (versus accrued) if any provision of the taxpayer’s incentive compensation plan (ICP) allowed for a forfeited bonus to revert to the taxpayer.

Under the taxpayer’s ICP, the aggregate amount of bonuses for book purposes was finalized at the end of the tax year based on the number of eligible employees at year end. The aggregate amount of bonuses paid generally did not exceed the amount accrued for book purposes at the end of the year. The ICP required eligible employees to remain employed with the taxpayer when the bonuses were paid in order to receive a bonus.

In February of the following year, the taxpayer’s compensation committee reviewed and approved the bonuses. The bonus accrual was provided as a lump sum to each of the taxpayer’s section managers who then allocated a bonus amount to his or her employees. If any employee left before the manager allocated the bonus amount, that employee forfeited the right to a bonus and the bonus amount was allocated among the remaining employees. If the manager finalized the individual bonus awards before an employee left, the forfeited bonus award was not allocated among the remaining employees; instead, the forfeited bonus award reverted to the taxpayer.

The taxpayer argued that the liability for bonus compensation was deductible in the year of service because the amount of bonuses actually forfeited represented a de minimis portion of the bonuses accrued at year end and paid by the 15th day of the third month following the end of the tax year. The taxpayer based its argument on Rev. Rul. 2011-29, 2011-2 C.B. 824.

In Rev. Rul. 2011-29, an accrual method taxpayer (X) established a bonus plan with a minimum total amount of bonuses payable through either (i) a fixed formula prior to year-end or (ii) other corporate action made by year-end, such as a resolution of X’s board of directors or compensation committee. Under the program, employees needed to perform services during the taxable year and be employed on the date of the bonus payment. Any bonus amounts allocated to employees who had left the company before the payment date were reallocated to the other eligible employees. Thus, the total bonus distribution amount was not affected by the departure of any employee. The bonuses were paid after the end of the taxable year of the related services and within 2 ½ months after the close of that year.

Based on these facts, the IRS stated that the fact of X’s liability for the minimum amount of bonuses was fixed by the end of the year in which the services were performed. Accordingly, the IRS determined that an employer can establish the “fact of the liability” under Sec. 461 for bonuses payable to a group of employees even though the employer does not know the identity or amount payable to and individual recipient until after the end of the taxable year.

In the ILM, the IRS concluded that the taxpayer’s liability was not a fixed liability in the year the services were performed. The IRS noted that once an individual’s bonus award was set, it was not reallocated to the remaining employees if that employee departed before the bonus was paid. Instead, such amounts reverted to the taxpayer. Consequently, the IRS stated that the liability was fixed only when the contingency, the employees still being employed on the date of payment, was satisfied. The IRS also provided that there was no de minimis exception to this rule. Accordingly, the IRS concluded that the taxpayer’s liability for bonus compensation is taken into account in the year in which the bonuses are paid if any contingency allows for a forfeited bonus to revert to the taxpayer.

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