For one thing only accrual-basis taxpayers can take advantage of the 2½ month rule – cash-basistaxpayers must deduct bonuses in the year they’re paid regardless of when they’re earned. Even for accrual-basis taxpayers however the 2½ month rule isn’t automatic. The bonuses can be deducted in the year they’re earned only if the employer’s bonus liability is fixed by the end of the year.
The all-events test
For accrual-basis taxpayers the IRS determines when a liability (such as a bonus) has been incurred – and therefore is deductible – by applying the “all-events test.” Under this test a liability is deductible when:
- All events have occurred that establish the taxpayer’s liability
- The amount of the liability can be determined with reasonable accuracy and
- Economic performance has occurred.
Generally the third requirement isn’t an issue; it’s satisfied when an employee performs the services required to earn a bonus. But the first two requirements can delay your tax deduction until the year of payment depending on how your bonus plan is designed.
For example many bonus plans require an employee to remain in the company’s employ on the payment date as a condition of receiving the bonus. Even if the amount of the bonus is fixed at the end of the tax year and employees who leave the company before the payment date forfeit their bonuses the all-events test isn’t satisfied until the payment date. Fortunately it’s possible to accelerate deductions with a carefully designed bonus pool arrangement.
How a bonus pool works
In a 2011 ruling the IRS said that employers may deduct bonuses in the year they’re earned – even if there’s a risk of forfeiture – as long as any forfeited bonuses are reallocated among the remaining employees in the bonus pool rather than retained by the employer. Under such a plan an employer satisfies the all-events test because the aggregate bonus amount is fixed at the end of the year even though amounts allocated to specific employees aren’t determined until the payment date.
Additional rules and limits apply to this strategy. To learn whether your current bonus plan allows you to take 2016 deductions for bonuses paid in early 2017 contact us. If you don’t qualify this year we can also help you design a bonus plan for 2017 that will allow you to accelerate deductions next year.