Amy Johnson



Aaron Wiegert

Many accrual basis taxpayers accrue employee bonuses as they are earned throughout the year—sometimes adjusting this accrual after year-end when final company results are known—and pay them the following year. According to conventional thinking, as long as the accrued bonuses were paid within two-and-a-half months of year’s end, the taxpayer could take the tax deduction in the year of accrual versus the year of payment. However, if the taxpayer fails to meet certain tests, this accelerated tax deduction may be in jeopardy.

It is important to first understand when a liability may be deducted for tax purposes. Under the accrual method of accounting, a liability is incurred and generally taken into account for federal income tax purposes in the taxable year in which all events have occurred to establish the fact of the liability, economic performance has occurred with respect to the liability and the amount can be determined with reasonable accuracy.

1. All events – A liability is incurred and taken into account for federal income tax purposes in the taxable year in which all events have occurred that establish the fact of liability. The all-events test is commonly met when the event fixing the liability has occurred or the payment of the liability is due. To meet this test, the liability must be free of any contingencies that could render the liability unsubstantiated.
2. Economic performance – The timing of economic performance is based on when the property and services are either used by the taxpayer or provided to the taxpayer. If the liability requires an entity to provide property or services to the taxpayer, economic performance occurs as the entity provides the services or transfers the property to the taxpayer. For bonus compensation, economic performance occurs as the employee performs the services that relate to earning the bonus compensation.
3. Reasonable accuracy – No liability may be taken into account before economic performance and all events fixing the liability have occurred. However, the fact an exact amount for the liability cannot be determined does not prevent the deduction. The taxpayer is allowed a tax deduction for the portion of the liability that can be determined with reasonable accuracy during the taxable year.

Items the IRS may focus on related to qualifying bonus compensation accruals include:

• Does the entity have a written bonus plan available for review by all employees?
• Were employees earning a bonus notified, either through written or oral communication, of the amount of bonus to be paid?
• Was the bonus plan, method of calculation and payment plan explicitly described and approved in the company board of directors’ minutes prior to year-end?

To achieve deductibility as of the company’s year-end, the bonus plan should not contain a contingency stating the employee must be employed at the time the bonus is paid. This contingency will cause the accrual to fail the all-events test.

An IRS Chief Counsel Advice memorandum released December 4, 2009, highlights the issue of bonus compensation accruals and the necessity to have them properly documented and fixed at the end of the tax year. The particular facts described may not apply to your company, but the memo emphasizes the importance of proper treatment of accrued liabilities, particularly bonus compensation. The issuance of such a document indicates bonus compensation accruals are an emerging issue and one that will most likely be scrutinized upon IRS examination. Taxpayers should recognize the importance of proper documentation and accrual accuracy to protect against a proposed adjustment in the event of an examination.

For more information or assistance with recording or documenting bonus accruals, please contact your BKD advisor.