Timing of Deduction for Certain Annual Bonus Arrangements
November 28, 2011
The Internal Revenue Service recently published Revenue Ruling 2011-29, which clarifies the application of certain rules concerning the federal income tax deductibility of annual bonus payments. Specifically, Revenue Ruling 2011-29 addresses when an employer may be able to deduct an annual bonus in the year with respect to which the bonus is earned, rather than the subsequent year in which it is paid. While we expect that the new Revenue Ruling will not impact the tax positions taken, or compensation practices adopted, by most of you, some may view the new guidance as confirmation of your prior tax positions or as an occasion to reconsider the structure of your annual bonus arrangements.
Generally, companies are permitted to deduct for federal income tax purposes compensation paid to employees only in the year in which the employee is required to recognize the compensation as income. This rule applies notwithstanding that the companies may be accrual-basis taxpayers. (This rule has a number of important exceptions, the substance of which are beyond the scope of this note.)
There is, however, an exception relevant to the payment of annual bonuses, which is commonly referred to as the “two and one-half month rule.” Under a temporary tax regulation (that has been in place since 1986), compensation for services rendered in a particular year that is paid within two and one-half months after the end of such year can be deducted in the year in respect of which it was earned, provided that the compensation could be accrued as of the last day of such year under generally applicable rules of tax accounting. Those rules provide that a liability can be accrued only in the taxable year in which (1) all the events have occurred that establish the fact of the liability (the “all events test”), (2) the amount of the liability can be determined with reasonable accuracy and (3) economic performance has occurred with respect to the liability.
Many companies require, in order for an employee to be entitled to receive an annual bonus, that the employee be employed on the day on which the bonus is paid. In such a plan, if the annual bonus is paid after the end of the year with respect to which it is earned the IRS generally takes the view that the accrual test cannot be met. There have been a number of court cases and regulatory statements concerning the application of the accrual standards to common annual bonus plan designs. (See, e.g., IRS Chief Counsel Memorandum 200949040, dated July 28, 2009, and the authorities referred to therein.)
Revenue Ruling 2011-29 addresses a plan with a continuing employment requirement under which the company obligates itself to, in effect, redistribute the bonus allocations from any employee who loses a bonus entitlement by reason of an employment termination to other active employees. The Revenue Ruling concludes that the all events test would be satisfied under these circumstances, notwithstanding that at the end of the relevant year the employer cannot be certain which employees will be entitled to receive bonuses (because the employment of one or more of them may not continue through the payment date) and, consequently, how much bonus will be paid to any of the eligible employees. The Revenue Ruling thus confirms the possibility that companies with “bonus pool” plan designs, under which a pool of bonus dollars is determined and distributed (in full) among all eligible employees, could be able to take advantage of the two and one-half month rule to accelerate its deduction for annual bonus payments to the year in respect of which the bonus is earned. (Public companies should note that such bonus pool plan designs that cover executive officers raise issues, unrelated to Revenue Ruling 2011-29, under Section 162(m) of the Internal Revenue Code.)
Copies of Revenue Ruling 2011-29 and IRS Chief Counsel Memorandum 200949040 are attached hereto for your convenience. Please feel free to call any of your regular contacts at the firm or any of the partners and counsel under Executive Compensation and ERISA or Tax in the Practices section of our website (www.cgsh.com) if you have any questions.
Generally, companies are permitted to deduct for federal income tax purposes compensation paid to employees only in the year in which the employee is required to recognize the compensation as income. This rule applies notwithstanding that the companies may be accrual-basis taxpayers. (This rule has a number of important exceptions, the substance of which are beyond the scope of this note.)
There is, however, an exception relevant to the payment of annual bonuses, which is commonly referred to as the “two and one-half month rule.” Under a temporary tax regulation (that has been in place since 1986), compensation for services rendered in a particular year that is paid within two and one-half months after the end of such year can be deducted in the year in respect of which it was earned, provided that the compensation could be accrued as of the last day of such year under generally applicable rules of tax accounting. Those rules provide that a liability can be accrued only in the taxable year in which (1) all the events have occurred that establish the fact of the liability (the “all events test”), (2) the amount of the liability can be determined with reasonable accuracy and (3) economic performance has occurred with respect to the liability.
Many companies require, in order for an employee to be entitled to receive an annual bonus, that the employee be employed on the day on which the bonus is paid. In such a plan, if the annual bonus is paid after the end of the year with respect to which it is earned the IRS generally takes the view that the accrual test cannot be met. There have been a number of court cases and regulatory statements concerning the application of the accrual standards to common annual bonus plan designs. (See, e.g., IRS Chief Counsel Memorandum 200949040, dated July 28, 2009, and the authorities referred to therein.)
Revenue Ruling 2011-29 addresses a plan with a continuing employment requirement under which the company obligates itself to, in effect, redistribute the bonus allocations from any employee who loses a bonus entitlement by reason of an employment termination to other active employees. The Revenue Ruling concludes that the all events test would be satisfied under these circumstances, notwithstanding that at the end of the relevant year the employer cannot be certain which employees will be entitled to receive bonuses (because the employment of one or more of them may not continue through the payment date) and, consequently, how much bonus will be paid to any of the eligible employees. The Revenue Ruling thus confirms the possibility that companies with “bonus pool” plan designs, under which a pool of bonus dollars is determined and distributed (in full) among all eligible employees, could be able to take advantage of the two and one-half month rule to accelerate its deduction for annual bonus payments to the year in respect of which the bonus is earned. (Public companies should note that such bonus pool plan designs that cover executive officers raise issues, unrelated to Revenue Ruling 2011-29, under Section 162(m) of the Internal Revenue Code.)
Copies of Revenue Ruling 2011-29 and IRS Chief Counsel Memorandum 200949040 are attached hereto for your convenience. Please feel free to call any of your regular contacts at the firm or any of the partners and counsel under Executive Compensation and ERISA or Tax in the Practices section of our website (www.cgsh.com) if you have any questions.