Your Annual Bonus May Not Be Deductible

Just paying the bonus by March 15 does not ensure it will qualify for a corporate tax deduction for the prior year.
Andrew LiazosOctober 24, 2011

It is quite common for corporations to pay bonuses based on calendar-year performance by the following March 15. Great care is taken to pay bonuses before that date so that a corporate tax deduction can be taken in the prior year.

Unfortunately, paying by March 15 does not ensure that the bonus is deductible for the prior year, and the Internal Revenue Service has recently been challenging many of these deductions. The timing of deductions for bonus payments is an important issue for CFOs, as auditors are increasingly looking for comfort with respect to these deductions under FIN 48.

The timing for the deduction of compensation that is deferred on an employee’s behalf (other than a tax-qualified plan) is usually tied to when it is paid to the employee. What’s not so well known is that paying the bonus by March 15 is not the only requirement. A bonus is deductible for a tax year only if the amount to be paid is a fixed liability by year-end and is reasonably ascertainable after that. All events must have occurred by year-end in order to determine the deductible amount for that year.

Many bonus-plan designs fail to meet these requirements. For example, a bonus may be conditioned upon the employee remaining employed with the employer on the payment date (absent special circumstances). As a practical matter, the employer won’t know the bonus amount to be paid until the following year. If forfeited bonuses can revert to the employer, expect that the IRS will challenge all bonus deductions taken in the year prior to payment.

One approach to address this problem is to require redistribution of forfeited bonuses to the employees who remain employed with the employer on the bonus payment date. While possibly palatable from a human-resources perspective, this bonus pool approach will not work for payments to named executive officers that are designed to meet the “performance based compensation” exemption to the $1 million deductibility limitation under IRS Section 162(m).

Even if there is not a requirement to be employed on the date of payment, bonus plans intending to qualify for the performance-based exemption will often have other problematic provisions. Many of these plans permit the compensation committee to have considerable discretion to reduce the amount payable to executive officers. When a plan has this provision, it will be very difficult, if not impossible, to deduct bonuses in the tax year prior to payment.

Concerned about potential financial accounting and tax exposure, many companies are reexamining the tax-accounting practices that are being used for their bonus plans. Reviews are relatively simple to undertake, and it may be possible to make changes that can eliminate or reduce this exposure.

Andrew Liazos heads the executive-compensation practice at law firm McDermott Will & Emery.