As the calendar year draws to a close, one item on the mind of many business owners is calculating year-end bonuses for employees. While relevant to employee performance and retention, bonuses and compensation accruals can also impact an employer’s tax obligations. Factors such as compensation type, timing of payment and the ultimate payee may alter the tax deductibility of these accruals.
Meet IRS Criteria When Establishing Accruals
First and foremost, in order for a compensation accrual to be deductible in the calendar year that the accrual originates, the compensation accrual must be established properly according to criteria set forth by the IRS. The criteria must be met for all compensation accruals including holiday pay, vacation pay and year-end bonuses. Criteria to establish proper compensation accruals includes:
- All the events have occurred that establish the fact of the liability.
- The business can determine the liability with reasonable accuracy.
- Economic performance has occurred with respect to the liability, meaning the employee has already provided the services for the accrued compensation.
- The accruals will be paid within two and a half months from the end of the calendar year.
Business owners should find these criteria pretty straightforward, but there are technical requirements that accompany the first, “all events” litmus test for bonus accruals. In order for bonus accruals to pass the “all events” test, they must follow additional rules set forth by the IRS. The criteria to satisfying the all events test for bonus accruals includes:
- The total amount of bonuses must be finalized by the end of the year, but the actual distribution to employees may be done after year-end.
- No amounts can revert back to the employer. In a situation where an employee leaves the company before a bonus is awarded, if that bonus is not allocated to the other employees in the bonus pool, the entire amount of year-end accruals becomes ineligible for deduction.
- For bonuses or accruals subject to review and approval by a board of directors or executive committee, that process must take place before the end of the year in order for those accruals to be deductible.
Exceptions to Deductible Compensation Accruals
Keep in mind that there are exceptions that preclude business owners from deducting compensation accruals, even if they met the criteria established above. The exceptions for owners and certain related parties are applied by entity type.
- S corporation shareholders (regardless of percentage owned): No accruals are deductible, including holiday and vacation pay.
- LLC members and partners: No accruals are deductible, including holiday and vacation pay, with the exception of guaranteed payments determined apart from the income of the partnership. These payments are deductible.
- C corporation owners (more than 50%): No accruals are deductible, including holiday and vacation pay.
- Certain related parties: No accruals are deductible, including holiday and vacation pay if an employee is considered a related person according to IRS rules.
Businesses always have the option to pay owner and related party compensation in cash to receive a current year deduction.
Your RKL advisor is available to help determine whether your compensation accruals or bonus payments meet the tax deductibility criteria. Contact one of our local offices today for more information or for assistance.
Contributed by Josie A. Parr, CPA, manager in RKL’s Tax Services Group. Josie specializes in providing tax planning and compliance solutions for businesses and individuals, including issues surrounding multi‐state taxation. She has considerable experience serving clients in a variety of industries including manufacturing, distribution, food processing, advertising and construction.