Question

As a corporation’s tax advisor, would you recommend that the

corporation gets a deduction for the planned bonuses paid next year but deducted by the business this year? Why or why not? Support you answers with tax code, cash basis and accrual basis.

Answer 1

Paying out bonuses to employees can be an effective motivational tool, and if we operate our business through a corporation, the good news is that bonus payments are generally tax deductible.

Law allows businesses 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). But this favorable tax treatment isn’t always available.

For one thing, only accrual-basis taxpayers can take advantage of the 2½ month rule — 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. The bonuses can be deducted 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:

• All events have occurred that establish the taxpayer’s liability,
• The amount of the liability can be determined with reasonable accuracy, and
• Economic performance has occurred.

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 your bonus plan is designed.

For example, many bonus plans require an employee to remain in the company’s employ 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.