How to "fix" an employee bonus liability.

• Author: Abdoo, Kate

PREVIEW

* The rules for when an accrual-method taxpayer may deduct liabilities for employee bonuses are nuanced, and practitioners must know the specifics of the rules to ensure that clients are not deducting bonuses in an improper year.

* As discussed in this article, whether an employer can take a deduction for bonus payments in the year before payment depends on the details of the bonus plan and when the payments are made.

* If an employer has been taking deductions for employee bonuses in the wrong year, it may be able to voluntarily correct the practice and gain audit protection through an automatic accounting method change.

The end of the calendar year is associated with many pleasant things--the holiday season, spending time with family and friends, time off from work, and, in some cases, bonuses from an employer. If the bonus is paid to the employee before year end and the accrual-method employer s liability is incurred so that the employer is able to take a deduction by year end, both parties are probably pretty happy.

But what if the employee is not paid until the following year? Under certain circumstances, the employer may nonetheless have a deductible liability at year end. However, the IRS and courts have increasingly ruled that any ability of the employer not to pay out some or all of its planned bonuses will keep the liability from fixing until that retained discretion is eliminated. Consequently, employers with discretionary bonus plans that restrict employees' right to receive a bonus may not be able to recognize the liability and take a deduction for bonus payments until the year after the related services are performed.

If an employer has been mistakenly taking a deduction in the earlier year (i.e., the year of services), the employer may be using an improper accounting method and (assuming it does not want to revise its bonus plans to eliminate the retained discretion) may have to request an accounting method change to correct the treatment and protect itself from exposure for prior-year treatment. Although inherently a timing issue, this could create a permanent impact for employers if income tax rates decrease in future years or for employers that are organized as flowthrough entities, where the owners are subject to higher income tax rates, and lead to exposure and the risk of penalties and interest for employers that are improperly recognizing the deduction in the year before payment is made.

Although the proper timing for recognizing a bonus liability' and taking the deduction for bonus payments is not a new issue, tax practitioners continue to find employers using impermissible methods of taking the deduction in a year prior to when it should be taken under accrual-method rules. Many times, this issue is discovered when an employer engages a new tax preparer or a new auditor. For financial statement purposes, employers using U.S. GAAP may be taking the liability into account in the year the related services are provided. While this may be acceptable for GAAP purposes, for federal income tax purposes the liability might not be deductible until the following year. Thus, employers that currently are following book treatment and are not calculating a Schedule M-l or M-3 adjustment on their return for bonus liabilities should, in particular, consider reviewing their bonus plans to determine whether such treatment is permissible.

This article discusses issues related to bonus liabilities of employers on the accrual method of accounting, when the bonuses are paid after the tax year in which the related services are performed by the eligible employee(s) but within 2 1/2 months after the year end. (1) This article describes when a liability generally is incurred and becomes deductible under the accrual-method rules and how these rules affect the timing of when bonus liabilities in particular may be deductible by accrual-method employers. (2) This article also discusses steps a taxpayer that is on an impermissible method of accounting for bonus liabilities may take to limit exposure for prior improper treatment and to correct treatment for current and future years.

Although this article provides a high-level overview of the rules regarding deducting bonus compensation liabilities for accrual-method employers, it is not intended to provide an all-encompassing discussion of every issue such liabilities may raise. (3) Practitioners should make sure to examine the client's specific facts and circumstances prior to determining the appropriate treatment of bonus liabilities and prior to taking any steps to change present treatment.

When Is a Liability Incurred for Federal Income Tax Purposes?

Accrual-method employers generally must wait until a liability is incurred before it can be taken into account (either through deduction or capitalization, as applicable). (4) The general rules for...