Tax Accounting and Employee Benefits Alert
Due in large measure to FIN48, a number of taxpayers have begun reexamining their methods of accounting for executive and employee performance and incentive bonuses (generically "year-end bonuses"). These reviews focus upon determining whether the taxpayer may accrue a federal tax deduction for year-end bonuses for the tax year in which the employee performs the related services.
Although the IRS has not identified the tax treatment of year-end bonuses as a "tiered" issue under its Industry Issue Focus program, there is a possibility that the IRS eventually may increase its scrutiny of this area. The recent addition of the tax accounting for year-end bonus payments to the list of those accounting methods eligible for automatic consent indicates that the IRS is aware of the increasing number of taxpayers faced with the need to change their methods of accounting for year-end bonuses. In anticipation of a potential increase in IRS scrutiny, taxpayers should review their current methods of accounting for year-end bonuses to determine what, if any, steps should be taken at this time.
In particular, taxpayers should review their year-end bonus plans to determine whether there is a fixed and determinable liability for bonus payments as of the end of the year in which the employees perform the related services. Many taxpayers' plans automatically create a tentative bonus pool as of the end of the year, but whether and how much of that pool will be paid to eligible employees is uncertain until the company's board of directors meets after year-end to approve the amount and payment of bonuses. In other cases, the taxpayer has no legal obligation to pay any amount to an individual whose employment ends prior to a specified date in the next tax year. In some cases, although provided by the bonus plan, the board's discretion to modify the tentative bonus pool is rarely exercised.
Under the "all events test" applicable to taxpayers using an accrual method of accounting, bonuses may not be deducted prior to the year in which the liability for the bonus is fixed, the amount is reasonably determinable, and economic performance occurs with respect to the bonus. Under this standard, the tax year in which a taxpayer may accrue all or some portion of its year-end bonus pool is a highly factual inquiry, and no conclusions should be reached without a detailed examination of the company's specific bonus plans. In general, the critical factors turn on the traditional two-prong "all events test," since the economic performance requirement typically will have been satisfied. The factors to consider include:
- As of the end of the year in which the employees perform the services, does the taxpayer have a fixed, contractual obligation to pay a determinable bonus pool to an identifiable class of employees?
- Must either the taxpayer's board or management take additional steps after the end of the year before the taxpayer is legally obligated to pay all or any portion of the bonus pool?
- Must an individual remain employed by the taxpayer for some portion of the following tax year to receive a bonus?
- If so, will the employee's departure prior to that date result in the forfeited bonus being redistributed among other eligible employees or instead will the employee's bonus be retained by the taxpayer?
The answers to these questions will largely determine the extent to which the taxpayer is entitled to accrue a deduction for year-end bonuses for the tax year in which the employee performs the related services. Where, based on this review, the taxpayer determines that it currently is accruing deductions for year-end bonuses prematurely, the taxpayer generally has two options.
First, the taxpayer should consider revising its bonus plans to include contractual terms that result in a fixed and determinable liability for year-end bonuses as of the year in which the employees perform the related services. This may require altering the extent to which the taxpayer retains discretion to determine or approve the amount of bonuses following the end of the year, or the manner in which that discretion is exercised. Accruing a deduction in the year in which the employees perform the services also may require modifying the manner in which employee departures affect the total bonus pool.
Second, in addition to or in lieu of amending existing plans, taxpayers should consider obtaining IRS consent to change the method of accounting for existing bonus plans. In Revenue Procedure 2008-52, 2008-36 I.R.B. (Aug. 18, 2008), the IRS has provided "automatic consent" to change the method of accounting for year-end bonus plans, subject to certain limitations. Taxpayers may use Rev. Proc. 2008-52 to change a method of accounting for year-end bonuses, effective as early as a calendar-year taxpayer's 2007 tax year (or more realistically, its 2008 tax year). Taxpayers under examination, however, remain subject to the general restrictions precluding voluntary accounting method changes except in certain limited circumstances (such as being within a "window period" or obtaining the consent of the Exam team to change the accounting method).
These two options are not mutually exclusive. Even where the taxpayer amends it year-end bonus plans to permit a deduction in the year in which the employees perform the related services, the taxpayer also should consider changing the method of accounting for its current bonus plans. Doing so offers a number of advantages that can be obtained only by means of a change in accounting method.
Miller & Chevalier's tax accounting and employee benefits specialists have significant expertise in this area. We are working closely with many clients to review their current methods of accounting for year-end bonuses and, where necessary, to amend their year-end bonus plans and/or change their methods of accounting for their current plans. We would be pleased to work with you on a similar review. Please contact one of the individuals listed below for further information.
For further information, please contact any of the following lawyers:
Fred Oliphant, firstname.lastname@example.org, 202-626-5834