In an IRS Field Attorney Advice Memorandum (FAA 20134301F) dated September 18, 2013, the IRS Office of Chief Counsel reviewed several common bonus plan designs in connection with a request for an opinion with regard to the timing of the employer’s tax deduction with respect to the accrual and payment of bonuses. Under the plans examined, annual employee bonuses were calculated using formulas that were largely driven by attainment of various metrics at the employer sector unit and individual employee level. Performance targets for the plan were set and approved by the board of directors during the first quarter of the fiscal year. The bonuses were generally not paid until after the committee of the board approved the bonus plan settlement and amount of the bonuses after the end of the fiscal year. An employee’s allocation under one of the bonus plans was a product of the employee’s individual performance scores and the company performance. Individual employee performance appraisals were finalized before the payment of the bonuses but after the end of the taxable year.
All of the bonuses under the various plans examined were paid after the end of the taxable year but on or before the 15th day of the third month following the end of the taxable year. The examined plans all required that employees be employed on the last day of the fiscal year but did not require that the employee be employed at the time that the bonuses were paid.
Under the terms of some of the plans, the board and plan committee reserved the right to modify or eliminate the bonuses prior to payment. Under the plans with such a reservation of rights, the IRS opined that there was no legally binding right fixing the liability at the end of the fiscal year and the “all events test” was not satisfied to justify a tax deduction. In addition, the amounts were not deductible because under the terms of the plans as of the end of the tax year, the accrued amounts were still subject to approval of the bonus computation and the payment. In the particular case the IRS examined, 2009 and 2010 bonuses included committee adjustments to the computations before the final amounts were approved and paid.
For those plans which required an assessment in determining the level or amount of bonus payable to the employees post-year end, the IRS found likewise that the “all events test” had not been satisfied at year end. The Service’s reasoning was that the tax accrual cannot take place any earlier than the date that the employee’s performance appraisal is completed. The IRS distinguished plans with an individual performance component from plans which are based upon purely mathematical metrics such as net operating profits, turn time, gross margins and other financial variables which are determined and fixed at year end. Even though the financial figures are subject to audited adjustments post year end, the IRS said that the fact of the liability and the amount of the liability can be determined for purposes of tax accrual as long as the variables on which the bonuses are to be based are fixed at year end, citing Revenue Ruling 55-446, 1955-2 C. P. 531 as modified by Rev. Rul. 61-127, 1961-2 C.B. 36.
Summarizing its Memorandum, the Chief Counsel Office stated that where bonus amounts are dependent in whole or in part on some subjective determination which is made after year end (such as a performance appraisal), the liability and the amount of the liability prongs of the all events test are not met because such subjective determinations are necessarily one of the events that set the fact and the amount of the liability.
Many accrual basis taxpayers have operated under the belief that so long as discretionary bonus amounts are paid within 2½ months following the end of the plan year, the amounts are fully deductible for the prior year. However, for bonus plans based on subjective performance criteria, the IRS may challenge the timing of the bonus deduction under the reasoning in its recent Memorandum.