Deducting a bonus accrued for an unrelated party.

• Author: Ellentuck, Albert B.

Facts

M&F Corporation is an accrual-basis, calendar-year corporation, owned equally by Minton and Floyd, who are not related. Minton devotes all of his working time to the corporation's business, while Floyd devotes only 50%.

Pursuant to the minutes of the directors' annual meeting, M&F is, to pay a bonus to Minton every December, based on the prior 12 months' profits. The corporation will be unable to pay the bonus this year (due to cash flow problems), but will accrue the bonus. Minton and Floyd have asked their tax adviser whether the accrued bonus will be deductible in the current year.

Issue

Can M&F deduct the accrued bonus, even though Minton will not recognize it as income until the next year?

Analysis

The first step the tax adviser should take in verifying that the accrued bonus is deductible is to determine whether Minton and the corporation are related. Under the related-party provisions, an individual and a corporation are not considered related unless the individual owns (directly or indirectly) more than 50% of the value of the corporation's stock. Minton and M&F are not related parties; he does not own more than 50% of M&F's stock. Thus, the deduction will not be limited based on the related-party rules.

Expenses payable to unrelated parties are generally deductible under the accrual method of accounting if - the all-events test is met, and - economic performance has occurred.

The all-events test is met if all the events that determine the fact of the liability have occurred and the amount can be determined with reasonable accuracy. Economic performance occurs when services or property creating the liability are provided to or by the taxpayer.

In connection with Minton's bonus, all of the conditions for accrual and deduction have been met. The fact of the liability has been established by the directors, the amount is calculated based on the prior 12 months' profit, and the services have been performed by Minton. However, the deductibility of accrued wages or bonuses requires the consideration of another provision - Sec. 404.

Sec. 404 deals with contributions to an employees' trust and compensation under a deferred payment plan...