Medical groups, hospitals and other healthcare organizations often accrue very large bonuses to physicians at year end, but many don’t realize that contingencies can make these bonuses non-deductible until paid. To avoid disallowance of your bonus expense deductions and related interest and penalties, you need to make sure your organization meets certain fundamental criteria.
Under IRC §461, an accrual basis taxpayer can deduct accrued bonuses if ALL of the following conditions are met:
Economic performance, with respect to compensation-related accruals, is governed by Regulation §1.404(b)-1T. To the extent that the accruals are paid out by 2 ½ moths after year end, the compensation can be deducted, as it falls outside of the definition of deferred compensation.
You may be thinking, “Excellent, as long as my organization pays accrued bonuses out within 2 ½ months after year end, we can deduct the bonus for tax purposes.” But beware, there is a trap!
Organizations often overlook the most fundamental criteria for deduction of an accrued bonus, which is that all events have to occur to establish the fact of the liability. In other words, the liability has to be “fixed” and exist without contingencies at year end.
The IRS clarified this in Revenue Ruling 2011-29, which involved a taxpayer who formulaically computed a bonus pool from which disbursements would be made to employees. This bonus pool was accrued as of year end, and the taxpayer did not determine the identity of the bonus recipients.
Additionally, the taxpayer’s bonus plan indicated that if an employee was terminated prior to the bonus pay-out date, any amounts forfeited by the terminated employee would be reallocated among the remaining recipients. The IRS ruled that the bonus accrual was fixed because the entire bonus pool would be disbursed, despite termination of participants.
Subsequently, IRS Chief Counsel Advice 201246029 examined a similar case in which forfeited bonuses of terminated employees reverted back to the taxpayer rather than being reallocated to the bonus pool for disbursement to the remaining participants. In this fact pattern, the IRS concluded that a contingency existed with regard to the bonus accrual, and the contingency was only satisfied if the bonus plan participant remained with the taxpayer through the bonus pay-out date. The IRS ruled that all events had not occurred to establish or fix the fact of the liability.
It’s essential to consider the overall terms and conditions of your bonus plan in determining the appropriate year of deduction. Deductions taken on contingent bonus accruals can result in disallowance of deductions and corresponding interest and penalty upon inquiry by a taxing authority.
If you have questions or need help analyzing the deductibility of your compensation plan, reach out to our experts.
