The Tax Treatment of Bonuses Presents Audit Exposure to Businesses

A company’s treatment of bonus accruals may create IRS audit exposure for accrual method taxpayers.

Under IRC Sec. 446, bonuses must meet an “all events test” to be accrued at year-end. The all events test requires that the bonus obligation be a fixed legal obligation at year end and the amount of that bonus obligation be determinable with reasonable accuracy. In short, the obligation must be payable in “all events.” In addition to the all events test, bonus deductions are deferred compensation that are subject to the Sec. 404 rule that the bonus must be paid within two and one-half months after the end of the year in which it is accrued. Both conditions must be satisfied for the bonus to be properly accrued.

Many bonus programs flunk the all events test because the bonus is subject to some discretion or risk after the end of the year. For example, the board may not approve the bonus pool until after financial statement earnings are determined or perhaps bonuses are paid only to employees who are still employed by the company on the date the bonuses are paid. Such discretion or risk is sufficient for the bonuses to fail to meet the all events test because it is not payable in all events, i.e., it is not payable if the board exercises its discretion not to approve the bonuses or one or more employees were to leave the company voluntarily or involuntarily before the bonuses are paid. Here, is it not important what actually happened but what might have happened. The fact that the board actually approved the bonus pool or no employee left the company does not cause the accrual to meet the all events test retroactively. Rather, it is the possibility that the bonus would not be approved and the possibility that an employee might leave that causes the entire bonus accrual to fail the all events test. Many bonus programs do not meet this test and therefore present IRS audit exposure. As a result, this item can become an uncertain tax position that must be considered during financial audits.

On the positive side, there is an opportunity to eliminate this exposure by filing an automatic accounting method change with the IRS national office. These filings provide a sort of tax amnesty complete with audit protection, relief from any interest and penalties, relief from the obligation to amend returns, and a four-year spread of the catch-up adjustment (in this case unfavorable to the taxpayer) that adds back the bonus accrual at the end of the year preceding the year of the method change. Such a filing may provide a tax cash flow benefit because of the favorable terms and conditions for such changes. There is also a further opportunity to restructure the company’s bonus program to meet the all events test in the future.

This issue has been the subject of heightened scrutiny by the financial audit firms and the IRS. Look for your financial auditor to give this item greater scrutiny this year.

To identify whether your company has this issue, here are the questions you need to consider:

  • Do you offer bonuses to your employees?
  • If so, is the bonus paid after the end of the year?
  • If so, is the bonus accrued for financial reporting and tax purposes?
  • If so, does the employee forfeit the bonus if not employed by the company on the payment date for the bonus? [If so, the bonus does not meet the all events test.]
  • Does the employee forfeit the bonus only if the employee breaches a contract, violates a company policy or commits an act of malfeasance before the payment date for the bonus? [If so, the bonus may still be accruable because the forfeiture is a “condition subsequent” that unfixes the right to the bonus rather than a “condition precedent” that prevents the accrual of the bonus in the first place.]
  • If the bonus is forfeited, is the forfeited bonus required to be allocated to other employees? [If so, the bonus may meet the all events test and be accruable.]
  • Is the bonus approved by the board or other committee or person authorized under the bylaws to approve bonuses before year-end? [If not, the bonus does not meet the requirement that there be a fixed legal liability at year-end.]
  • Is there a discretionary aspect of the determination of the bonus that has not been resolved at year-end, e.g., client satisfaction surveys, subjective evaluations by managers, etc? [If so, the bonus will not satisfy the all events test at year-end unless there is some portion of the bonus that is not discretionary.]

If the responses to these questions indicate that the company’s bonus program does not meet the all events test at year-end, an automatic method change is available that generally can be made for either the 2009 or 2010 tax years under Rev. Proc. 2008-52 as updated by Rev. Proc. 2009-39. If the change is made in 2009 or 2010, and is then resolved by the end of 2010, there could be a substantial additional timing benefit from the change in method. This is because the catch-up adjustment to account for the change in method is spread over four years, the delayed 2009 deduction under the new method is taken into account in full in the year of payment, and the accrual at the end of 2010 may be deducted if the program terms are modified so that the deduction meets the all events test at year-end. Thus, an amount deducted in full incorrectly in 2009 may be deducted again in 2010, this time correctly under the new proper method. Additionally, the add-back from the 2008 deduction is spread over the 2009 through 2012 years, one-fourth each year. Depending on the numbers, a change in method in 2009 may be more beneficial than one in 2010 or vice versa. Therefore, modeling is necessary to determine an appropriate year to change the company’s method.

The opportunity to restructure involves correcting the aspect of the bonus program that causes it to fail the all events test, e.g., accelerate board approval, have the board approve a bonus pool that would be split among remaining eligible employees if one employee were to leave, make a portion of a fully discretionary bonus formulary so that at least part of the bonus meets the all events test at year-end.

If your company has this issue, it is not too late to make a change for 2009. Even companies that have already filed tax returns can amend those returns to make an automatic method change by taking advantage of an automatic extension to file by the extended due date of the return. Alternatively, the company may choose to make this change in 2010 instead. There is no obligation to make the change in the earlier of the two years. In short, a change in accounting method change can give this cloud a silver lining.