Annual bonus plans: managing audit exposure.

• Author: Atkinson, James L.

Whether a company may deduct compensatory bonuses in the same year in which the employees provide the services for which they are being rewarded is attracting increased attention from both financial and IRS auditors. The issues arising from both forms of audit scrutiny are taking many companies by surprise, because the current deductibility of amounts paid under their annual bonus plans has gone largely unchallenged for many years.

Increasingly, companies are being told by their financial auditors that they have been accounting for annual bonuses improperly, and that the company either must begin deferring those deductions to a later year or establish a FIN48 reserve for the payments. With the Internal Revenue Service's recent announcement that companies may be required to provide greater "transparency" of the issues for which they have established reserves, determining the correct year in which to deduct annual bonuses is taking on even greater importance.

Most companies have one or more compensatory bonus plans for employees. Many have separate plans for managers and for non-managers. Companies also typically have separate bonus plans for highly compensated individuals (so-called section 162(m) plans). The structure and terms of these plans vary significantly from employer to employer, but two common provisions have led to substantial angst regarding the ability to deduct bonuses in the same year in which the employee performs services ("the service year").

Discretion to Reduce Pool

Many plans provide a formula or other mechanism for creating a year-end bonus pool to be shared among eligible employees, but reserve to management the ability to increase or decrease the actual amount paid to employees once year-end financial results become available and other indicia of individual, business unit, and company performance have been considered. In many cases, this discretion takes the form of requiring the Board of Directors, the compensation committee, or the CEO or CFO to review and approve the amount of the bonus pool before any amount becomes due and payable under the plan.

Because, under this plan design, these decisions necessarily occur after the close of the service year, such provisions raise the issue whether for tax purposes the "all events test" has been satisfied as of the end of that year. Under this standard, the company cannot deduct any portion of the bonus pool for the service year unless its liability is fixed and the amount is reasonably determinable as of the close of that year. Where the company has no obligation to pay any bonuses unless and until designated officials or the Board's compensation committee approve the amount to be paid, there is a substantial risk that the financial auditors and the IRS will conclude that the company does not have a fixed and determinable liability as of the end of the service year. Instead, the deduction is deferred until the following year, when these "conditions precedent" to payment of the bonus are satisfied. (1) Both the financial auditors and the IRS are likely to take this position even if the company rarely if ever modifies the amount determined under the formula.

Paying the bonuses within two and a half months of the end of the service year is not sufficient to support deduction in the service year. The so-called two-and-a-half-month rule under section 404 only determines...