Bonus deduction timing: finding the correct tax year.

• Author: Martin, Jeffrey A.

It is common practice for an employer to maintain an annual bonus plan to attract, retain, and provide incentives to employees who are key to the business's growth. Employers often spend a great deal of time designing a bonus plan to meet these goals. But employers should not stop there. They should also consider how the bonus arrangements affect their income tax obligations at the end of the year.

In most circumstances, the optimal outcome is for the employer to deduct the bonus in the year it is earned, rather than the year it is paid. Many businesses believe that as long as they pay the bonuses within 21/2 months after the end of the tax year in which the bonus is earned, the bonus is deductible in the year it is earned, rather than the year paid. Unfortunately, this is not always true. Many factors determine when the bonus is deductible.

This item focuses on an employer's ability to deduct bonuses in the tax year they are earned rather than the tax year in which they are paid to the employee. This includes a discussion of a recently released IRS field attorney memorandum (Field Attorney Advice (FAA) 20134301F). This item refers to ABC Co., a hypothetical employer that uses the accrual method of accounting, and its employee, Tom, to illustrate the deduction timing rules. ABC is a calendar-year taxpayer that pays the bonus to Tom within 21/2 months after the end of ABC's tax year in which Tom earns the bonus (i.e., by March 15), which avoids the deduction timing rules under Sec. 404 that apply to deferred compensation and that may result in deferring the deduction until the year it is paid.

Assuming ABC pays Tom his bonus within 21/2 months after the end of the tax year in which Torn earns the bonus, Sec. 461 governs the timing of ABC's tax deduction. If ABC were a cash-basis taxpayer, the timing of the deduction would be simple. Regs. Sec. 1.461-1(a)(1) allows the deduction in the year the bonus is paid. If ABC were a cash-basis taxpayer and paid Tom his 2013 bonus in February 2014, ABC would deduct the bonus in 2014.

The Sec. 461 rules are much more complex when considering an accrual-method taxpayer. Regs. Sec. 1.461-1(a) (2) provides that under an accrual method of accounting, a liability (e.g., an accrued bonus) is incurred, and generally deductible, in the tax year in which (1) all events have occurred to establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred for the liability. The first two prongs are referred to as the all-events test. This test has received increased attention over the past few years in the form of official and unofficial IRS guidance. These two prongs are the subject of this item. The third prong, economic performance, is satisfied when the employee performs the services related to a bonus. This prong has not received increased attention.

All-Events Test

As discussed above, the all-events test is met in the tax year in which (1) all events have occurred to establish the fact of the liability, and (2) the amount of the liability can be determined with reasonable accuracy. When is the fact of a liability established?

In Rev. Rul. 79-410, the IRS addressed how the all-events test applies to a noncompen-sation accrued liability. In this ruling, the IRS stated that "all events have occurred that determine the fact of the liability when (1) the event fixing the liability, whether that be the required performance or other event, occurs, or (2) payment therefore is due, whichever happens...