Employee Benefits Alert
The Internal Revenue Service (IRS) has ruled that under certain circumstances an accrual basis taxpayer may accelerate the tax deduction for its payroll tax liability attributable to deferred compensation to a taxable year preceding the taxable year in which the taxpayer is allowed to deduct the deferred compensation to which the payroll tax liability relates. While the ruling clarifies that section 404(a)(5) does not apply to the taxpayer’s payroll tax liability, it leaves unanswered when the taxpayer’s payroll tax liability is otherwise fixed.
In Rev. Rul. 2007-12; 2007-11 IRB 1, the IRS held that if the “all events test” and the “recurring item exception” of section 461 of the Code are otherwise met, an accrual basis taxpayer may treat its payroll tax liability (i.e., its liability under section 3111(a) and (b) of the Code for the employer’s portion of the Federal Insurance Contributions Act (FICA) taxes and under section 3301 of the Code for the Federal Unemployment Tax Act (FUTA) tax) as having been incurred in Year 1, the year the taxpayer has a fixed liability to pay compensation for services provided to it in Year 1 by its employees, regardless of whether the compensation to which the payroll tax liability relates is deferred compensation that is deductible by the taxpayer only in Year 2 pursuant to section 404 of the Code.
Under the facts of Rev. Rul. 2007-12, the taxpayer was a corporation that used an accrual method of accounting and filed its federal income tax returns on a calendar year basis. As of the end of Year 1, the taxpayer had a fixed liability to pay compensation for services provided by its employees during Year 1. As of the end of Year 1, all events had occurred to establish the fact of the taxpayer’s liability for the payroll taxes related to the compensation, and the amount of the payroll tax liability could be determined with reasonable accuracy. Importantly, the taxpayer had adopted the recurring item exception under Treas. Reg. § 1.461-5 as a method of accounting with respect to the payroll taxes. In satisfying the recurring item exception, the taxpayer paid the payroll taxes either (1) in Year 1 or (2) before the earlier of September 15th of Year 2 or the date the taxpayer filed a timely (including extensions) federal income tax return for Year 1. The deduction under section 404 of the Code for the deferred compensation was properly taken in Year 2.
The key legal conclusion reached by Rev. Rul. 2007-12 was that section 404(a)(5) of the Code, which ties the employer’s deduction for deferred compensation to the time the compensation is included in the gross income of the employee, does not control the timing of the employer’s deduction for the payroll taxes related to such deferred compensation. Rather, the timing of the deduction for the payroll taxes is controlled by the timing rules for deductibility under section 461 of the Code, unfettered by the matching rule under section 404(a)(5).
In the case of an accrual basis taxpayer, the deductibility rules under section 461 require that (1) all events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. With respect to the liability to pay a tax, the regulations provide generally that economic performance occurs as the tax is paid to the governmental authority that imposed it. This general economic performance rule would preclude the ability of a taxpayer to deduct payroll taxes in a year prior to the year in which the tax is paid. However, the regulations also provide a “recurring item exception” to the general economic performance rule for tax liabilities. Under the recurring item exception, a tax liability is treated as incurred for a taxable year if: (1) at the end of the taxable year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy; (ii )economic performance (i.e., payment of the tax) occurs on or before the earlier of (a) the date that the taxpayer files a timely (including extensions) return for the taxable year, or (b) the 15th day of the 9th calendar month after the close of the taxable year; (iii) the liability is recurring in nature; and (iv) either the amount of the liability is not material or accrual of the liability in the taxable year results in better matching of the tax liability against the income to which it relates than would result from accrual of the liability in the taxable year in which economic performance occurs. In the case of a liability for taxes, this matching requirement is deemed satisfied.
Rev. Rul. 2007-12 specifically revokes Rev. Rul. 69-587. In that earlier ruling, the IRS concluded that under the all events test of section 461 of the Code, an accrual method taxpayer could not deduct payroll taxes payable with respect to bonuses and vacation pay accrued and vested but unpaid at year-end until the taxable year in which the bonuses and vacation pay were paid.
It is interesting to note that Rev. Rul. 2007-12 does not refer in its analysis to the special timing rule of section 3121(v)(2), requiring that any amount deferred under a nonqualified deferred compensation plan must be taken into account as wages for FICA tax purposes when the services are performed and the compensation is vested (similar rules apply in the case of the FUTA tax), nor does it specify in its facts when the applicable payroll taxes were deposited. Based on informal conversations with the Government, we understand that this omission was intentional, and that even if the payroll taxes were payable in year 1 under section 3121(v)(2), the IRS felt that there was still an open issue that needed to be addressed: whether the deduction deferral rule of section 404(a)(5) would postpone, not only the deduction of the deferred compensation, but also the related payroll taxes attributable to such compensation. It is also important to remember that not all compensation subject to the deduction deferral rule of section 404(a)(5) is subject to the special timing rule of section 3121(v)(2) ‑‑ for example, section 3121(v)(2) does not apply to certain welfare benefits, including vacation pay, sick leave, and severance benefits, which may still be subject to section 404(a)(5) ‑‑ so in those instances, there would be no obligation to deposit payroll taxes early.
There is also a related point involving section 3121(v)(2) that should be noted. If the compensation at issue is subject to a short-term deferral under that provision (that is, the taxpayer pays the compensation within two and one-half months of year-end), the taxpayer can elect to not apply section 3121(v)(2). In that situation, there is a question of whether the taxpayer’s liability for the payroll taxes on the compensation is fixed. See Eastman Kodak Co. v. United States, 534 F.2d 252 (Ct. Cl. 1976) (taxpayer’s liability for payroll taxes on accrued bonuses and vacation pay not fixed at year-end because employee might exceed the payroll tax ceiling when taxpayer pays compensation). Rev. Rul. 2007-12 is premised on the payroll taxes otherwise being fixed. Therefore, a taxpayer must look to other authority to determine whether its liability for the payroll taxes on such compensation is fixed at year end.
As noted above, Rev. Rul. 2007-12 provides accrual basis taxpayers with the opportunity to deduct payroll taxes attributable to deferred compensation in a year prior to the year the deferred compensation may be deducted. A taxpayer seeking to take advantage of this opportunity must obtain the consent of the Commissioner to a change in method of accounting within the meaning of sections 446 and 481 of the Code and the regulations issued thereunder.
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