In Revenue Ruling 2011-29 (the 2011 Ruling), the Internal Revenue Service addressed the deductibility of bonus payments when the amount of the bonus pool is determined by year-end but the individual amounts for employees are not then fixed. In the 2011 Ruling, the IRS held that an accrual-basis taxpayer met the first prong of the so-called “All Events Test” for determining deductibility of bonus payments made under the following arrangement:
Bonuses are paid pursuant to a program that defines the terms and conditions under which bonuses are paid for a taxable year;
The employer communicates the terms (and any changes) to eligible employees;
- Bonuses are paid for services performed during the taxable year;
The minimum total amount of bonuses payable is determinable either through
- A formula that is fixed prior to the end of the taxable year and takes into account financial data for that tax year; or
- Other corporate action (e.g., a board of directors’ resolution) made before the end of the taxable year that fixes the bonus payable to the employees as a group;
- To receive a bonus, employees must perform services during the taxable year and be employed on the date the bonuses are paid;
- The bonuses are paid after the end of the tax year to which they relate but before the 15th day of the third calendar month after the close of the taxable year; and
- Any bonus allocated to an employee who is not employed on the date bonuses are paid is reallocated among other eligible employees.
The All Events Test
Internal Revenue Code Section 461 and the corresponding regulations provide that under an accrual method of accounting, the All Events Test determines whether and when a liability is incurred and taken into account for federal income tax purposes. To satisfy this test:
- All the events must have occurred that establish the fact of the liability;
- The amount of the liability can be determined with reasonable accuracy; and
- Economic performance has occurred for the liability.
Prior guidance from the IRS indicates that all events occur to establish the fact of a liability when:
- The event fixing the liability, whether required performance or another event, occurs; or
- Payment is unconditionally due.
Therefore, the guidance provides that an expense may be deductible before it is due and payable; however, the liability for such an expense must be firmly established.
Effect of the 2011 Ruling
Prior to the 2011 Ruling, there was tension between the IRS and judicial decisions regarding the first prong of the All Events Test. In particular, the United States Court of Claims decided in Washington Post Co. v. United States, 405 F.2d 1279 (Ct. Cl. 1969), that a taxpayer incurred a liability to pay bonuses under a plan in which the actual amount and time of the payout to individual recipients were, at least in part, not determined because the liability to pay the aggregate amount was fixed at the end of the taxable year. The IRS responded in a 1976 revenue ruling that it would not follow the Washington Post case in similar cases.
In the 2011 Ruling, the IRS revoked the 1976 ruling, effectively agreeing with Washington Post that the inability to identify the ultimate recipients and the amount, if any, that each eligible employee will receive under a bonus pool program is irrelevant for purposes of determining whether all the events have occurred to establish the fact of the liability. Thus, the IRS concluded that the bonus arrangement described in the 2011 Ruling will satisfy the first prong of the All Events Test.
Many employers in the financial services industry and elsewhere create bonus pools for high-performing employees. However, the allocation of the individual bonuses is often not known prior to the end of the taxable year to which the bonus relates. The amount may not be known because, under the bonus plan, an employee has to be employed on the payment date or because the plan may give some discretion about making individual allocations. The 2011 Ruling should provide comfort that an employer using an accrual method of accounting may still record a compensation expense deduction despite not being able to identify the specific employees who will receive a bonus and the amounts of the individual bonuses, so long as the aggregate bonus liability (i.e., the size of the bonus pool) has been fixed by year-end by formula or other corporate action.
The other position in the 2011 Ruling that will be helpful to many individual bonus arrangements is the IRS’s recognition that the amount due under a bonus formula can be calculated after year-end and still be deductible for the prior year (i.e., the year in which the services were performed). For example, a bonus based on fiscal-year profit cannot be determined on the last day of the fiscal year because financial calculations need to be made, but all events have occurred except the ministerial task of making the calculation.
There are some common bonus situations that have been the subject of disputes with the IRS that are not covered under the 2011 Ruling.
- Code Section 162(m) generally limits the deduction for compensation paid to an employee of a publicly traded company to $1 million annually, with a significant exception for certain types of performance-based compensation. Most bonus plans subject to the Section 162(m) deduction limit give the employer’s compensation committee the right to exercise negative discretion on the amount of a formula bonus. Some other plans reserve the discretion to reduce the size of the bonus pool. The 2011 Ruling’s requirement that any bonus not paid to one employee be reallocated to other employees is not consistent with Section 162(m) practices or the retention of discretion to otherwise reduce the size of a bonus pool. Therefore, the IRS could continue to dispute the deduction in the year before payment in these cases.
- Many bonus plans outside of Section 162(m) allow the employer discretion to pay more than the minimum amount determined under a formula. Under the 2011 Ruling, any amount paid in addition to the formula amount would not be deductible in the year before payment is made, even if paid within two and a half months of the prior year-end.