Accelerating FICA and FUTA tax deductions for vacation and bonus pay.

• Author: Godshalk, Rich
• Position: Federal Insurance Contributions Act, Federal Unemployment Tax Act

Rev. Rul. 2007-12 holds that if the all-events test and recurring-item exception of Sec. 461 are otherwise met, an accrual-method taxpayer may deduct FICA and FUTA tax expenses (payroll taxes) in the year that the deferred compensation to which they relate is earned, regardless of whether that deferred compensation is deductible in a later year under Sec. 404. Unfortunately, it does not address the issue of when the all-events test is satisfied with respect to payroll taxes on deferred compensation. This item discusses questions about the application of the all-events tests to payroll taxes on two of the most common forms of deferred compensation: vacation pay and bonuses.

Rev. Rul 2007-12

The revenue ruling presents the following fact pattern:

1. X, a calendar-year, accrual-method corporation, has a fixed liability to pay compensation for services provided by its employees at the end of year 1, which is deductible under Sec. 404 in year 2;

2. As of the end of year 1, all events have occurred to establish X's liability to pay the payroll taxes related to the compensation, and the amount of the liability can be determined with reasonable accuracy; and

3. X has properly adopted the recurring-item exception under Sec. 461 for payroll taxes and pays the payroll taxes before the earlier of 8 1/2 months after the end of year I or the date X files its income tax return for year 1.

   The question presented is whether in this situation the payroll taxes on the deferred compensation can be deducted in year 1 if, under Sec. 404, the underlying compensation is not deductible until year 2. The ruling states that, while the compensation underlying the payroll taxes is subject to Sec. 404, because the payroll taxes themselves are not compensation, they are not subject to Sec. 404. Accordingly, they are subject to the accrual rules under Sec. 461, under which an expense is accrued in the year the all-events test is met (and the requirements for the recurring-item exception are met, if applicable). In this case, because all the requirements of the test and the exception are met for the payroll taxes in year 1, they are deductible in that year, even though the compensation is not deductible until year 2 under Sec. 404.

   What Rev. Rul. 2007-12 Does Not Say

   Rev. Rul. 2007-12 concludes that under certain circumstances payroll taxes attributable to deferred compensation expenses, which include vacation and bonus pay, may be deductible for a tax year that is earlier than the tax year in which the deferred compensation is deductible. Unfortunately, Rev. Rul. 2007-12 sets forth these certain circumstances in a conclusory fashion, providing no fact patterns or accompanying analysis as to when these conclusions are appropriate. With respect to vacation or bonus pay, in some common situations it is uncertain whether a taxpayer will meet the all-events test for payroll taxes on deferred compensation in the year that compensation is earned.

   Satisfaction of the All-Events Test

   Underlying compensation: Specifically, the revenue ruling does not address whether certain "termination of pay" provisions that are common to vacation and bonus pay plans render the all-events test unsatisfied at the end of the employer's tax year in which the employees "earn" the vacation and bonus pay through their provision of services. Deduction of the payroll taxes for the tax year in which the employees earn the vacation and bonus pay through their provision of services is dependent, in part, on the employer-taxpayer's satisfaction of the all-events test for its vacation and bonus pay liabilities at this tax year end.

   The common "termination of pay" provisions referred to above include:

1. Vacation pay expense--"use-or-lose" provision. A common feature of most vacation pay expense plans is that an employee must use the vacation pay by the end of the vacation pay plan year that follows the vacation pay plan year in which the employee earned the vacation pay, e.g., vacation pay earned in calendar year 2006 must be used by the end of calendar year 2007. If the employee does not use such earned vacation pay by the end of the following year, and the employee retains employee status on that date, the employee forfeits the vacation pay. Generally, employees are paid their earned vacation pay on voluntary termination of employment and on involuntary termination other than for cause.

2. Bonus pay expense--"employment on payment date" provision. Typically, bonus pay expense plans provide that an employee who has otherwise earned the bonus pay will forfeit such compensation if the employee on the date the bonus pay is payable is no longer an employee. The loss of employee status would be...