November 23, 2011
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:
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:
Prior guidance from the IRS indicates that all events occur to establish the fact of a liability when:
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.
For additional information related to this new guidance or any other questions regarding structuring of employee bonus programs, please contact the authors or any other member of our Executive Compensation and Employee Benefits team.