We previously have written about the requirements and nuances of the deductibility of annual bonuses under Code Section 461. Most recently, in December 2013 (“More Guidance on the Timing/Deductibility of Annual Bonus Payments”), we described the IRS’ attempt to clarify and tighten the requirements of Code Sec. 461 with Chief Counsel issuing Field Attorney Advice Memorandum 20134301F and we expressed doubt that all employers were complying fully with its requirements.
In August 2015, the Commissioner of Internal Revenue took an aggressive enforcement stance against Health Care Service Corporation (HCSC) and its subsidiaries, issuing a notice of deficiency for $28.5 million in tax owed for the 2007 taxable year for annual bonuses paid to employees in 2008, but attributable to 2007. The IRS also imposed an underpayment penalty of $5.5 million, claiming that HCSC’s position was not even in even good faith!
Code Requirements for Deductibility
Code Sec. 461 generally allows an employer to deduct in its Year One tax year bonuses that it pays to employees within the first 2½ months of Year Two (for example, for a calendar-year employer, payment by March 15, 2016, for a deduction in 2015) and the employees are not taxed until Year Two. Treas. Reg. Sec. 1.461-1(a)(2)(i) provides that, under the accrual method of accounting, a liability is incurred and is generally taken into account for federal income tax purposes in the taxable year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy, and (3) economic performance has occurred with respect to the liability. Thus, this 2½-month grace period into the next fiscal year only applies if “all events” fixing the obligation have occurred by the end of Year One. To the extent that a company’s bonus plan requires an employee to remain employed until the actual payment date in Year Two, the plan may not satisfy the all events test and the deduction may not be available until the Year Two tax year.
However, in FAA 20134301F and other previous rulings, the IRS has set forth means by which an employer can satisfy the all events test even if it requires employees to remain employed until the actual payment date in Year Two in order to receive payment.
- The bonus plan must be in existence in Year One, and covered employees must earn bonuses under the plan for their Year One performance.
- The employer must not retain the unilateral right to modify or eliminate the bonuses at any time prior to payment.
- Amounts paid under the employer’s bonus plan must not be subject to approval by a committee of the employer’s board of directors before being paid.
- The computation of amounts paid under the employer’s bonus plan must not be dependent on subjective factors, such as employee performance appraisals.
- The employer must establish the amount of the total bonus pool available to employees for Year One no later than December 31 of Year One.
- Participating employees could compel the employer to pay bonuses for Year One, determined by the terms of the bonus plan.
The employer would not be required to satisfy all of these requirements in order to secure deductibility in Year One. For example, if the employer approved a fixed bonus pool amount at the end of Year One, but applied subjective criteria to determine the amount of each individual employee’s bonus, it should be able to satisfy the all events test for deductibility.
Health Care Service Corporation v. Commissioner
In November 2015, HCSC paid the tax and penalties and petitioned the Tax Court for a redetermination of the deficiency in income tax for the taxable year ended December 31, 2007 (2007). During 2007, petitioner had approximately 16,000 employees. HCSC operated on a calendar year tax period and used the accrual method of accounting for Federal income tax purposes during the 2007 tax year. HCSC paid bonuses to certain employees with respect to 2007 to reward the employees for achieving certain corporate, divisional, and personal performance goals under the terms of a bonus plan that existed and was in effect during for 2007 (the “2007 Bonus Plan”).
HCSC employees earned bonuses for their 2007 performance pursuant to the terms of the 2007 Bonus Plan. The amount of the total bonus pool available to employees for 2007 was established no later than December 31, 2007. The 2007 Bonus Plan provided for a total bonus pool to be paid to the employees based on pre-established fixed and objective formulas specific to 2007. HCSC’s Compensation Committee adopted the formulas for 2007 in January 2007. The formulas for the 2007 Bonus Plan were based on attaining certain corporate and divisional goals during 2007. HCSC announced in 2007 the bonus formulas to participating employees in 2007 shortly after HCSC’s Compensation Committee adopted the 2007 Bonus Plan. Participating employees could compel HCSC to pay bonuses for 2007, determined by the formulas in the 2007 Bonus Plan.
HCSC accrued $111,250,000 for 2007 with respect to bonuses to be paid pursuant to the 2007 Bonus Plan. Based on the formulas for determining the bonus pool pursuant to the 2007 Bonus Plan, HCSC paid bonuses of $98,885,370 on or before March 15, 2008. The IRS did not dispute that HCSC was ultimately entitled to the deduction. Rather, the IRS claimed that HCSC was only entitled to the deduction in 2008, not in 2007.
HCSC petition argues that it should be able to deduct the $98,885,370 in bonuses paid under the 2007 Bonus Plan because:
- The liability to pay was not contingent as of the end of the 2007 tax year.
- The liability with respect to the bonuses to be paid under the 2007 Bonus Plan was fixed and unconditional as of the end of the 2007 tax year.
- HCSC’s liability to pay bonuses pursuant to the Bonus Plan was capable of being objectively measured as of the end of the 2007 tax year.
- The 2007 Bonus Plan formulas were sufficiently detailed to determine with reasonable accuracy on or before December 31, 2007, the amount of HCSC’s bonus liability for 2007.
- Economic performance for the amount of bonuses paid with respect to the 2007 Bonus Plan occurred as HCSC’s employees performed services in 2007.
- HCSC paid bonuses to employees on or before March 15, 2008.
Unused bonus monies from the bonus pool under the 2007 Bonus Plan did not revert to HCSC. Any unused bonus monies remaining after the 2007 bonus payments to employees on or before March 15, 2008, were required to be disbursed during the balance of the 2008 year in accordance with special recognition award guidelines. HCSC did not deduct on its 2007 Federal income tax return the bonuses HCSC paid to employees after March 15, 2008, pursuant to HCSC’s special recognition award guidelines.
Until IRS files its answer to HCSC’s petition, it is difficult to determine exactly what component of HCSC 2007 Bonus Plan and procedures failed to satisfy Code Sec. 461. Apparently the IRS is arguing that bonuses under the 2007 Bonus Plan were not properly deductible because each and every participating employee’s 2007 bonus was not determined by December 31, 2007. Stay tuned.