If you use an accrual method of accounting and allocate money to a bonus pool, you can breathe a sigh of tax deductible relief. The IRS has concluded that employers can take a current tax deduction for a fixed amount of bonuses that will be paid to employees during the next year, even though the amount that each employee will receive, and even the identity of employees, aren’t known until after the tax year ends. (Rev. Rul. 2011-29, IRB 2011-49)
Here’s how it works
The IRS used these facts to illustrate:
Mega is a calendar year taxpayer and pays bonuses to a group of employees. The minimum total amount of bonuses payable to all eligible employees is set before the year ends, and is based on a formula that considers Mega’s financial data as of the end of that year. Alternatively, Mega’s board of directors can set the total bonus pool before the year ends.
Bonuses are paid after the year ends and before March 15 (i.e., the 15th day of the third calendar month after the end of the year). Employees forfeit their bonuses if they terminated employment before the date bonuses are paid. Any forfeited amounts go back into the bonus pool and are split among the remaining participants.
Facts of liability. Under the accrual method of accounting, you can take a deduction before you actually incur an expense, but only when all the events have occurred that establish the fact of the liability for that expense.
The issue for the IRS was whether this all-events test was met, even though the employees, and the amounts of their individual bonuses, were unknown when the deduction was taken. It ruled that it was.
IRS: Mega’s liability to pay a minimum amount of bonuses to the group of eligible employees was fixed at the end of the year in which employees’ services were rendered. Bonuses allocated to employees who terminated were reallocated to other employees. Therefore, the fact of Mega’s liability to pay a minimum amount of bonuses was fixed by the end of the year.