Don’t make a mistake with accrued bonuses that may delay the deduction to next year.
Most people know that accrued bonuses payable to non-owners of S-Corps and LLCs must be paid by 3/15/14 for calendar year taxpayers to deduct them in 2013. For bonuses to owners or related parties, they must be paid by 12/31/13.
Another requirement, that most don’t pay attention to, is that the accrual has to meet the rules for deducting liabilities under Code Section 461 and applicable regulations, which are:
1) The Economic Performance Rule. Economic performance occurs as the services generating the bonus are performed. Pretty easy rule to satisfy.
2) The All Events Test. This rule is another story. It is satisfied when the liability legally exists and the amount can be determined with reasonable accuracy. Many taxpayers fail the test and don’t even know it. They incorrectly accrue and deduct the liability. They wait until after year end to determine and accrue the bonus. Technically, it wasn’t a legally enforceable liability on 12/31.
Several IRS Rulings and Field Service Advice have been issued in recent years regarding the rule. Use of a formula and a pool of identifiable employees is permitted, even though it can’t be calculated until after year end and the exact amount allocated to the specific employees isn’t known as of year end. Also, if all or a portion of the accrued amount potentially may not end up being paid to employees (for example due to termination before payment), that portion doesn’t meet the all events test.
Make sure you adopt a legally enforceable plan prior to year end for how bonuses will be calculated and what employee or group of employees will share in the bonus pool. Declare the amount in board minutes or via an employee communication before year end, if possible.
Planning is the key. Make sure to bring this up to your accountant this month. January to too late.
I spent the weekend in Florida on my new (used) 28 foot open bow SeaRay boat with my buddy Bill fishing and taking an online tax course. Bill nailed the fish. We had a couple of beers too. Great time. I’m back in freezing Minnesota for December tax planning. Fun, fun, fun.