Tax

IRS Dives into the Bonus Pool

Employers can now enjoy the tax benefits of their incentive payments even when some bonus earners are unknown.
Robert WillensNovember 29, 2011

Reversing a position it had maintained for 36 years, the Internal Revenue Service ruled in November that a corporation can deduct the entire amount of its bonus pool even though incentive payments for some employees can’t be determined before the end of the year.

Now, as long as the minimum amount of the bonus pool is fixed as of the end of the year, employers using accrual accounting can claim the whole bonus pool for federal income-tax deduction purposes, according to IRS Revenue Ruling 2011-29. This revenue procedure is effective for bonuses paid or incurred in taxable years ending on or after April 8, 2011. Previously, the IRS had held that the deduction couldn’t be claimed until both the identity of the bonus recipient and the specific amount of that bonus were known.

In the case at hand, the company, which we’ll call X Corp., used an accrual method of accounting for tax purposes. X paid bonuses to a group of employees under a program that defines the terms and conditions under which the bonuses are paid for a taxable year. Under the program, bonuses were paid to X’s employees for services performed during the taxable year.

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X determined the minimum total amount of bonuses payable under the program to its employees as a group in one of two ways. It could, on one hand, be calculated via a formula that’s fixed before the end of the taxable year. It could also be allotted through such a “corporate action” as a resolution by the board of directors or the compensation committee that is made before the end of the taxable year.

To be eligible for a bonus, an employee had to perform services during the taxable year and be employed on the date X paid bonuses. Under the program, bonuses were paid after the end of the taxable year in which the employee performed the related services but before the 15th day of the third calendar month after the close of the taxable year.

Any bonus amount allocated to an employee who wasn’t employed on the date on which X paid bonuses was reallocated among other eligible employees. Thus, the aggregate minimum amount of bonuses X paid to its group of eligible employees wasn’t reduced by the departure of an employee after the end of the taxable year but before bonuses were paid for that year.

The fact of X’s liability for the minimum amount of bonuses was hence established by the end of the year in which the services were rendered. That was true even though the identity of the ultimate recipients and the amounts each employee would receive couldn’t be determined before the end of the taxable year.

Under the “all-events test” in U.S. Treasury regulations governing the accrual method of accounting, a liability is incurred and generally taken into account in the taxable year in which (a)all the events have occurred that establish the fact of the liability, (b)the amount of the liability can be determined with “reasonable accuracy,” and (c)economic performance has occurred.

Thus, the IRS reasoned, all the events had occurred by the end of the taxable year that establish the fact of X’s liability to pay the minimum amount of bonuses. An employer can thus establish the “fact of the liability” for bonuses payable to a group of employees even though the employer does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the year. Reasonable as it sounds, that decision was a long time coming.

Robert Willens, founder and principal of Robert Willens LLC, writes a tax column for CFO.com.