Deducting deferred bonuses: Numerous rules and restrictions govern the timing of the deductibility of bonuses that are accrued in one year and paid in another.

• Author: Ellentuck, Albert B.

A current deduction for accrued bonuses is allowed only if a bonus is actually received (not merely constructively received) by the employee within 2 1/2 months of year end (Sec. 404(a)(11)). Any payments made after this 2 1/2-month period are deductible by an accrual-basis corporation in the tax year in which the payments are included in income by the recipient.

Controlling shareholder

An accrual-basis C corporation is allowed a deduction for accrued bonuses payable to a cash-basis controlling shareholder as of the day the compensation is received (actually or constructively) by the shareholder (Sec. 267(a)(2)). In a C corporation, a controlling shareholder is one who owns (directly or indirectly) more than 50% of the value of the corporation's stock (Sec. 267(b)(2)). Thus, an accrual-basis C corporation is placed on the cash basis tor deducting compensation accrued, but not yet paid, to a controlling shareholder.

Example 1. Accrued bonus payable to a related C corporation owner: A owns 60% of T Inc., an accrual-basis C corporation with a Dec. 31 year end. The corporation accrues a $10,000 bonus for A on Dec. 31, year 1, and pays it on Jan. 5, year 2. Since A owns more than 50% of the stock, T cannot deduct the accrued bonus until the year A recognizes the income, which is year 2.

Observation: The IRS ruled that a taxpayer constructively received his accrued salary on the last day of the corporation's year because the salary was authorized for that year by the corporation he controlled, and it was financially able to pay the salary. Furthermore, the employee kept the corporate books and had the power to draw the salary. The corporation was allowed a deduction in the year of the accrual, but the shareholder had to recognize the salary as income in the year before actual receipt (Rev. Rul. 72-317; IRS Letter Ruling 8630059).

Personal service corporation

An accrual-basis personal service corporation (PSC) cannot deduct salaries and bonuses owed to any cash-basis shareholder (or someone related to a shareholder) until the payment is included in the payee's income (Sec. 267(a)(2)).

Restriction on retention bonuses

The IRS stated that bonuses subject to a contingency cannot be accrued in year 1 to be paid in year 2 even if paid within 2 1/2 months of year end (Chief Counsel Advice (CCA) 200949040). Therefore, if employees cannot receive their deferred bonuses for performance in year 1 unless they are still employed on the year 2 bonus payment date, the company's liability for the bonus is subject to a contingency and cannot be accrued in year 1. In this fact pattern the economic performance piece of the all-events test is not passed as of the end of year 1.

Similarly, the IRS held that bonuses were not fixed in the year of service when the amount of individual awards were finalized but reverted back to the company if an employee left before receiving the bonus, even though the forfeited amounts could be considered insignificant (CCA 201246029).

However, Rev. Rul. 2011-29 provides that an employer can establish the "fact of the liability" under the first prong of the all-events test (Sec. 461) for retention bonuses payable to a group of employees even though the employer does not know the identity of any...