Making Sure Your Year-end Bonus Accrual is Deductible This Year
‘Tis the season for bonuses. Companies frequently accrue year-end bonuses and then pay them shortly after year-end. The IRS has provided additional guidance and, not all unpaid bonuses may be deductible in 2010.
Generally, for an accrual basis taxpayer to be able to deduct accrued but unpaid bonuses, three tests must be met: 1) all events must have occurred that established the fact of the liability, 2) the amount of the liability can be determined with reasonable accuracy, and 3) economic performance has occurred.
Employee compensation is normally deductible in the year that the payment is includable in the gross income of the employee. Generally, that means when the employee is actually paid. However, an exception is made for year-end bonuses. If the employee is paid within two and one-half months after year-end and the taxpayer is obligated for the payment prior to the end of the year, an accrual basis taxpayer can deduct it in the year of accrual.
In 2009, the IRS clarified the rules (Letter Ruling 200949040) that when an employee is required to be employed at the time of the payment, the deduction is in the year paid. Because the employee has to provide services to obtain the bonus after the end of the year, economic performance does not occur until payment is made.
Companies should carefully review their bonus plans before the end of the year to make sure the accrual is deductible in 2010. Key points to consider are if the plan:
- Requires the employee to be employed at the payment date
- Fixes the amount of the bonus or establishes a reasonable formula for its calculation. This could be a problem if the calculation is based on audited results since the audit will not have been completed prior to year-end.
- Requires board or key management approval. If so, be sure that the approval is made and documented before year-end