Passing bonus muster

Employee bonus plans can be tricky. Unless all the i’s are dotted and t’s crossed, the Internal Revenue Service can impose penalties, some quite substantial.

While the IRS has issued several rulings that may cast doubt upon the deductibility of many employers’ current bonus plans, they also shed light on how to structure a bonus plan to withstand IRS scrutiny.

Businesses with annual employee bonus plans have long operated under the assumption that as long as they pay bonuses within 10 weeks after the end of the year in which the bonuses are earned, the bonuses are deductible in the year earned, rather than in the year paid. While this is true, other requirements must be met as well.

For taxpayers using the accrual method of accounting, a liability generally is deductible under the “all-events test” in the taxable year in which: All events have occurred that establish the fact of the liability, the amount of the liability can be determined with reasonable accuracy and economic performance has occurred with respect to the liability.

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Economic performance with respect to compensation generally occurs when the services creating the right to the compensation are performed. Compensation paid to an employee more than 10 weeks after the end of the employer’s tax year, however, is not deductible until the year it is paid.

The IRS has issued a series of rulings illustrating situations where bonuses were not deductible until the year in which they were paid because the fact of the liability had not become fixed by year end. These include:

n If a bonus plan requires that employees still be employed by the taxpayer on the date that bonuses were paid in order to receive that compensation, and any unpaid bonuses by virtue of an employee’s termination of employment revert back to the employer, then no employee bonuses are deductible until the year paid since the bonus liability is subject to a contingency and is not fixed by year end.

n If the aggregate amount of bonuses to be paid becomes fixed by year end via a formula or some other corporate action, and any forfeited bonuses due to an employee’s termination of employment are reallocated among other eligible employees, then bonuses paid within 10 weeks of the employer’s year end are deductible in the year the services were rendered.

Last fall, the IRS issued a ruling that digs even further into the nuances of employee bonus plans and how easily they can fail to establish a fixed liability by year end, thus delaying the deduction for the bonuses until the year in which they are paid.

The bonus plans discussed in this ruling were largely formula driven, yet each of them was subject to some action after year end that caused them to fail the “all-events” test:

n Reservation of right to modify or cancel bonuses: Even if a bonus plan contains a fixed formula for determining the amount of employee bonuses, if under the bonus plan the employer reserves the right to unilaterally modify or cancel the bonuses prior to payment, the employer has no legal obligation to pay the bonuses and, thus, they are not deductible until actually paid to the employees.

n Required approval of bonuses: Even if an employee bonus plan is based on numerical targets that are established during the year in which the services are performed, if the calculated bonuses still must be approved by the board of directors or a compensation committee before they can be paid, and that approval does not take place until after year end, the bonuses are not deductible until they are paid.

n Bonuses based on performance appraisals: If some portion of the pre-established bonus formula is based on the employees’ individual performance scores, and those performance scores are based on individual performance appraisals that are not completed until after year end, then the fact of the liability has not been established by year end. •

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