November 16, 2011
Authored by: benefitsbclp
The IRS recently released Revenue Ruling 2011-29 clarifying the deductibility of bonuses. The question posed in the Ruling was:
“Can I deduct a bonus in the current tax year if I know how much I will pay in bonuses by the end of the year, even if I don’t know who will get them until next year?”
The Facts: The more detailed facts are as follows:
A company (we’ll call it “X” to protect the innocent) uses an accrual method of accounting for federal tax purposes. X pays bonuses to a group of employees pursuant to a program that defines the terms and conditions under which the bonuses are paid for a taxable year. X communicates the general terms of the bonus program to employees when they become eligible and whenever the program is changed.
Under the program, bonuses are paid to X’s employees for services performed during the taxable year. The minimum aggregate amount of bonuses payable under the program to X’s employees as a group is determinable either (a) through a formula that is fixed prior to the end of the year, taking into account financial results as of the end of that year, or (b) through other corporate action, such as a resolution of X’s Board or Compensation Committee, made before the end of the taxable year, that fixes the total bonuses payable to the employees as a group. To be eligible for a bonus, an employee must perform services during the taxable year and be employed on the date that X pays bonuses. Under the program, bonuses are paid after the end of the year in which the services are performed, but before the 15th day of the 3rd month after the end of the year.
Under the program, if an employee is not employed on the date bonuses are paid, then any bonus amount that would have been paid to an employee is reallocated among other eligible employees. This is a key fact. Thus, the aggregate minimum amount of bonuses X pays to its group of eligible employees is not reduced by the departure of an employee after the end of the taxable year but before bonuses are paid.
The Question (again): Can X deduct the bonus in the year it’s earned as opposed to the year it is paid?
The Answer: Logically, it would seem that since the amount is fixed by the end of the year, it should be deductible in that year. In this case, the law agrees with logic and the IRS said that the bonus was deductible in the year the aggregate amount of bonuses was determined.
The Caveats: First, this only applies to companies who are accrual basis taxpayers. Second, the Ruling says that if you have been deducting bonuses like this in the year they are paid, then changing is considered a change in accounting method which can only be accomplished in accordance with IRS procedures. Third, if forfeited bonuses are not re-allocated to remaining eligible employees, the result is different because the aggregate minimum amount of bonuses X will pay is not fixed by the end of the taxable year.