The year-end bonus is a great way for employers and employees to celebrate the holiday season. Employers can take a deduction for the payments, as long as the deduction is taken in the year the services are performed.
What happens if, in all the end-of-the-year hoopla, you don’t actually get the bonus payments made until January? Or what if you don’t have the cash until January? The IRS and courts have ruled that companies who are accrual-based and paying in the following calendar year after the services for the bonus were performed, are using an improper method of accounting.
The AICPA recently released a publication explaining that the real issue is with discretionary bonus plans that restrict employee’s right to receive a bonus. Employers with this type of bonus structure will usually be required to take the deduction the following year.
If companies don’t want to revise their bonus plans to get rid of the retained discretion, they’ll need to request an accounting method change to cash-based.
Here are the details of how these deductions work, and what to do if you’ve gotten the timing wrong.
Liability, Accrual Method, and Deductions
Accrual-method employers are usually required to wait until a liability is incurred before it can be taken into account. Under Sec. 461 (for federal income tax purposes) a liability is taken into account in the tax year when all the events happened that establish the fact of the liability. In the case of bonuses, because they’re viewed as a reward for an employee’s year of work, they place the bonus liability in that year of work.
It gets a little complicated because there’s another factor coming into play with bonus liability: the liability must be “fixed” before it can be recognized. It’s not enough just for the services to have been performed. Thus, the courts have ruled that a taxpayer can’t deduct a liability that’s contingent or contested.
This becomes a factor when the discretionary bonus plan includes language and provisions that, in the IRS’s (and many courts’) view, will keep the liability from fixing until any uncertainty created by that discretion is eliminated. So the key factor in determining whether an employer has a fixed liability for bonus payments is whether that employer has a legal obligation to pay the bonuses.
How to Correct Improper Accounting Issues for Bonus Deductions
If the IRS says that you’ve taken a deduction for bonuses in an improper tax year, you can usually correct the problem by simply changing your accounting method. You’ll just need to file a Form 3115, Application for Change in Accounting Method.
If you voluntarily correct an improper accounting method, and if you’re not already under IRS examination, you will most likely receive audit protection. You’ll also be able to spread the income pickup over four tax years.
There are several specific guidelines and limitations that apply to individual cases, so you’ll want to talk with your tax professional to find out the implications for your own situation.