Deductions for Bonus Plans

Attempting to ensure an accelerated deduction.

any annual bonus and long-term incentive plans provide for payments to participants within 2 1 / 2 months of the end of the employer’s tax year, so the employer can deduct the payments in the prior tax year (for example, for a calendar-year employer, payment by March 15, 2004, for a 2003 deduction). But the plan also must meet other requirements. CPAs should become familiar with these rules in order to advise eligible clients.

Under IRC section 461 and the regulations, an accrual-basis taxpayer generally can deduct expenses that meet the all-events test: (1) All events have occurred that determine the fact of the liability, and (2) the amount of such liability can be determined with reasonable accuracy. In addition, the test is met for any item only if “economic performance” (such as the employee performance that triggered the bonus payout) has occurred.

Many employers sponsor annual bonus or incentive plans, under which eligibility or payout is based on certain annual measures (for example, sales, productivity and personal performance ratings). Both the plan’s terms and the payment’s timing are critical in determining payment deductibility.

For plans that pay awards within 2 1 / 2 months of the employer’s yearend, the plan terms determine whether the employer can deduct the awards for the year just ended or in the payment year. To satisfy economic performance and the all-events test, the award amounts and the obligation to pay must be fixed by yearend.

A plan based entirely on financial data (for example, return on assets or sales growth) should meet the requirement that bonus amounts be fixed as of yearend, because the information needed for calculating the bonus is available at yearend (even if the numbers still need to be audited).

The requirement that participants’ rights to bonuses be vested (that is, the obligation to pay the bonuses be fixed) as of yearend can be met in one of two ways. An individual participant’s right to a bonus may be vested at yearend. Even if the person quits the following year (but before the bonus is paid), he or she still would be entitled to it.

Conversely, an employer can set up a fixed-dollar bonus pool and provide for it to be allocated among and paid to employees who satisfy the plan’s terms as of the payment date. If the employer has to pay out the bonus pool—even if only one employee ultimately meets the requirements—the all-events test should be satisfied.

Amounts paid more than 2 1 / 2 months after the end of the tax year are generally presumed to be deferred compensation. Under IRC section 404(a)(5), contributions to a nonqualified deferred compensation plan are deductible in the tax year the contribution is includible in the gross income of the employees participating in the plan. A separate account must be maintained for each employee. The employer takes the deduction in the year the employee recognizes the compensation income (that is, the payment year).

For more information, see the Tax Clinic, edited by Annette Smith, in the July 2003 issue of The Tax Adviser.

—Lesli Laffie, editor
The Tax Adviser

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