Accrual-basis taxpayers may be allowed to deduct bonuses employees have earned during a tax year if the bonuses are paid within 2½ months after the end of that year (by March 15 for a calendar-year company). Cash-basis taxpayers must deduct bonuses in the year they’re paid, regardless of when they’re earned. Even for accrual-basis taxpayers, however, the 2½ month rule isn’t automatic. Employers can deduct bonuses in the year they’re earned only if the employer’s bonus liability is fixed by the end of the year.
The all-events test
For accrual-basis taxpayers, the IRS determines when a liability (such as a bonus) has been incurred — and, therefore, is deductible — by applying the “all-events test.” Under this test, a liability is deductible when:
Generally, the third requirement isn’t an issue; it’s satisfied when an employee performs the services required to earn a bonus. But the first two requirements can delay your tax deduction until the year of payment, depending on how you design your bonus plan.
For example, many bonus plans require an employee to remain employed by the company on the payment date as a condition of receiving the bonus. Even if the amount of the bonus is fixed at the end of the tax year, and employees who leave the company before the payment date forfeit their bonuses, the all-events test isn’t satisfied until the payment date. Fortunately, it’s possible to accelerate deductions with a carefully designed bonus pool arrangement.
How a bonus pool works
In a 2011 ruling, the IRS said that employers may deduct bonuses in the year they’re earned — even if there’s a risk of forfeiture — as long as any forfeited bonuses are reallocated among the remaining employees in the bonus pool rather than retained by the employer. Under such a plan, an employer satisfies the all-events test because the aggregate bonus amount is fixed at the end of the year, even though amounts allocated to specific employees aren’t determined until the payment date.
Additional rules and limits apply to this strategy. To learn whether your current bonus plan allows you to take 2016 deductions for bonuses paid in early 2017, contact me at HZemel@BerdonLLP.com or your Berdon advisor.
If you don’t qualify this year, we can also help you design a bonus plan for 2017 that will allow you to accelerate deductions next year.
Hal Zemel, a Tax Principal at Berdon LLP, New York Accountants, has more than 20 years in public accounting and advises businesses in the real estate, service, and manufacturing sectors.