Like many contractors, you may distribute safety and performance bonuses for the previous year’s work after year end. Until recently, you could deduct these “bonus accruals” on your tax return for the “performance year” (rather than the “payment year”) only if by the end of the performance year you specified exactly how much each eligible employee would receive.
Now, under IRS Revenue Ruling 2011-29, bonus accruals may be more easily deductible in the year accrued. This may be beneficial because it allows you to accelerate the deduction, deferring tax.
Read the ruling
Under the ruling, to deduct bonuses for the performance year rather than the payment year, you don’t need to know exactly how much each employee will receive; you need to know only which employees are potentially eligible for bonuses and the amount of the bonus pool. This gives you more flexibility when doling out bonus payments.
For example, before year end you can establish by either a written plan or a board decision that you’ll pay safety bonuses from a pool of $50,000 to a group of 20 employees that had no recordable safety incidents for the year. As long as you comply with the other rules (see “Follow the requirements” below), you can make certain (though limited) adjustments after year end to how you distribute that bonus pool.
Another provision of the ruling is that you can calculate bonuses after year end and still deduct them for the performance year. For instance, if you base your bonuses on your fiscal-year profit, you may not be able to determine the bonus pool on the last day of the fiscal year because you still need to make financial calculations. As long as you’ve completed all necessary documentation except for the calculations, you can calculate the bonus amounts in the new year.
Follow the requirements
Although Revenue Ruling 2011-29 has eased the requirements for accelerating bonus deductions, you still need to comply with several rules. You can claim the bonus accrual deduction for the performance year rather than the payment year only if:
• You use the accrual method of accounting,
• You establish minimum bonus amounts for the group of employees eligible for bonuses by the end of the tax year for which you’d like to take the deduction,
• When you pay out the bonuses, you reallocate any bonus set aside for an employee who is no longer with the company to other eligible workers,
• The bonus plan specifically identifies which employees are eligible to participate,
• You communicate the plan requirements to eligible employees before the end of the tax year,
• You establish the formula for calculating bonuses before the end of the tax year — preferably in a documented formula, and
• You pay bonuses by the 15th day of the third month after the close of the tax year.
Beware: Should you claim a deduction for bonus amounts that aren’t fixed at the end of the performance year — such as a bonus that you can increase or decrease at your discretion — the IRS may challenge the deduction.
Ask for help
If you’re considering a 2012 deduction for 2012 performance bonuses paid in early 2013, make sure your construction company is complying with the Revenue Ruling. Should you wish to qualify to deduct 2013 performance bonuses paid in early 2014 on your 2013 returns, start revising your 2013 bonus plans now.
Bear in mind that the IRS considers a change in how you treat bonuses for tax purposes an accounting method change. Documentation supporting this change would be due with your tax return for the year in question. Ask your tax advisor for help.
Exceptions to the Revenue Ruling
Some common bonus situations not covered under IRS Revenue Ruling 2011-29 (see main article) have triggered disputes with the agency.
For example, tax treatment won’t be the same in most cases where an owner is in the bonus pool, though the rules vary based on entity type. For C corporations, bonuses paid to owners whose direct or indirect ownership exceeds 50% aren’t deductible until the company pays them. This limit drops to ownership greater than 2% for S corporations. No bonus accrual is deductible for a bonus paid to a partner in a partnership or a member in a limited liability company that’s taxed as a partnership.
In addition, for publicly traded companies, Section 162(m) of the federal tax code typically limits the compensation deduction to $1 million annually per “covered employee” (the CEO and the next three most highly paid officers other than the CFO). But there’s a significant exception for certain types of performance-based compensation. To qualify for the exception, among other requirements there must be either a formula for calculating the compensation or a statement of the maximum amount an employee can receive.
To retain some flexibility while still qualifying for the exception, most bonus plans subject to the Sec. 162(m) deduction limit give the employer’s compensation committee the ability to reduce the bonus amount. Other plans reserve the discretion to reduce the size of the bonus pool. Such flexibility is inconsistent with Revenue Ruling 2011-29’s requirement that any bonus not paid to one employee be reallocated to others. Because of this, some publicly held companies could face IRS challenges to their deductions.
For more information contact Dan Lacey at [email protected].