For many companies, the beginning of the New Year is not only a time for setting new goals and challenges, but also for reflecting on the successes of the previous year. If your company enjoyed a profitable 2014, you’re likely planning on sharing that good fortune with the folks who helped make your success possible: your employees.
Like most financial decisions in business, there are tax consequences to how you structure your bonus plan. Reviewing your policies periodically will ensure you are staying in compliance with your written policies, that the policies are being properly administered and that you have an opportunity to update them to best suit your current business plans and outlook.
As you review your bonus plan policy, here are a few things you want to keep in mind:
- Does your company have a written bonus plan policy? Does it match up with how you’ve been administering it in recent years? Having a written plan that outlines policies such as when the bonus will be paid and what happens to a terminated employee’s bonus is critical to ensuring compliance, creating transparency and ensuring consistency in the policy’s administration.
- Does it provide that all employee bonuses must be paid before the end of the business year or within two and a half months after the end of the business year? In general, accrual-method business taxpayers can deduct a liability when it meets the three-part, all events test. Under this test, the timing of a tax deduction will be sustained if 1) all events have occurred to determine the fact of the liability; 2) the liability can be determined with reasonable accuracy; and 3) economic performance has occurred with respect to that liability. Therefore, bonuses awarded and paid before the end of the business year will be deductible for tax purposes in that year. Bonuses accrued at year-end, but not paid until the next year, will require closer examination.
- Does your plan provide for a pool of money to be paid as bonuses to your employees? Must the employee remain employed with you through the date of payment to be eligible for the bonus? The IRS has ruled that as long as the bonus pool is paid out within two and a half months after the end of business year, and all money forfeited by terminated employees remains in the bonus pool to be reallocated, it will be deductible in the year services were performed. If the terminated employee’s bonus reverts back to the employer, then the entire bonus pool is deemed to be a contingent liability and none of it is deductible for tax purposes until it is actually paid.
At RKL, our professionals have reviewed and provided feedback on numerous bonus plan documents on behalf of our clients. While many contain similarities, each bonus plan document needs to be specific to the unique needs of a business. Take time to review your bonus plan document with your tax advisor to understand how it affects your current income tax liability. With some help, you’ll discover there are ways to structure your policy in way that meets your desire to incentivize your employees while providing your business a current income tax deduction.
Contributed by Debby H. Wells, manager, RKL’s Tax Services Group. Debby has over 20 years of public accounting tax-related experience. She specializes in middle-market federal and multi-state corporate and pass-through entity tax planning and compliance. She also provides tax outsourcing services to public companies and private businesses to aid them in computing quarterly (and annual) income tax accounting provisions for their financial statements.