Small Business Taxes & Management^TM--Copyright 2011, A/N Group, Inc.

The Basics

Cash basis businesses generally report income when it's received and expenses when the check is sent. Businesses using the accrual method report income when the income is earned (e.g., work performed, product shipped) and expenses when the liability is incurred (e.g., work is performed for the business, title taken to goods). But the rules can get more involved in the accrual method. And, to add to the complexity, IRS rules for deducting expenses (and recognizing income) are sometimes different than the accounting rules.

An expense is generally considered incurred if the following three tests are met:

• All events have occurred that determine the fact of the liability,
  
• A taxpayer's liability can be determined with reasonable accuracy, and
  
• Economic performance has occurred with respect to the liability.

For example, Madison Inc. (a calendar-year taxpayer) orders six tons of fertilizer on December 15, 2011 for $2,400. Chatham Feeds accepts the order, ships on December 28 and title passes at that time. All three tests have been met and Madison can accrue a $2,400 expense for 2011.

Assume the facts are the same as in the example above, but Madison does not want the fertilizer shipped until April 20, 2012. Under the general rule Madison could not accrue the $2,400 at the end of 2011.

The rules and situation described above are the most commonly encountered. The IRS regulations provide for a number of other situations. One involves deferred compensation. You can only accrue salaries and bonuses if they're paid within 2-1/2 months after the end of the year. For example, in December 2011 Madison decides to give Fred Flood, its lead engineer, a $19,000 bonus, but won't pay it until February 2012. As long as the payment is not subject to a substantial risk of forfeiture at the end of 2011 and Madison pays the bonus by the 15th day of the third month after the end of the year (March 15th for a calendar-year business), Madison can accrue the $19,000 bonus at the end of the year. Madison also decides to pay a bonus of $15,000 to the manufacturing supervisor, but the terms of his bonus require him to remain in Madison's employ until the bonus is paid. Madison can't accrue the supervisor's bonus.

Caution. You can't accrue a bonus or salary for certain related parties. Such an item is deductible only when paid. For example, Sue Sharp is the president of Madison Inc., an S corporation, and a 60% shareholder. The board declares a bonus of $50,000 to be paid in February, 2012. The amount cannot be accrued at the end of 2011. This rule applies to other certain other expenses such as rent and constructive ownership rules apply (e.g., Sue only owns 30%, but her father owns 25%; she's deemed to own 55%).

Revenue Ruling 2011-29

The IRS has just issued a revenue ruling (Rev. Rul. 2011-29) on deferred compensation. The facts were that Madison pays bonuses to a group of employees pursuant to a program that defines the terms and conditions under which the bonuses are paid for the year. Madison communicates the general terms of the program to employees when they become eligible and whenever the program is changed.

Under the program, bonuses are paid to the employees for services performed during the taxable year. The minimum total amount of bonuses payable under the program to the employees as a group is determinable either (a) through a formula that is fixed prior to the end of the year, taking into account financial data reflecting results as of the end of that taxable year, or (b) through other corporate action, such as a resolution of Madison's board of directors or compensation committee, made before the end of the year, that fixes the bonuses payable to the employees as a group. To be eligible for a bonus, an employee must perform services during the taxable year and be employed on the date that Madison pays bonuses. Bonuses are paid after the end of the taxable year in which the employee performed the related services but before the 15th day of the 3rd calendar month after the close of that taxable year.

Under the program, any bonus amount allocable to an employee who is not employed on the date on which Madison pays bonuses is reallocated among other eligible employees. Thus, the total minimum amount of bonuses Madison pays to its group of eligible employees is not reduced by the departure of an employee after the end of the year.

The IRS held that the bonus amount was deductible for the year it was accrued because Madison could establish the fact of the liability under Sec. 461 for bonuses payable to a group of employees even though Madison does not know the identity of any particular bonus recipient and the amount payable to that recipient until after the end of the year.

The important point was that the total amount of the liability was fixed. Any bonus allocable to an employee who is not employed on the date on which the bonuses are paid is reallocated to other eligible employees.

Audit Item

IRS agents are on the lookout for bonus payments made after the end of the year. The Service knows that many companies pay bonuses after yearend and that more than a few don't meet the fixed liability requirement, but instead just accrue an amount. If the bonuses are contingent and can be forfeited and revert back to the employer, or the amount is not determinable, the IRS is likely to deny the deduction.

The best advice here is to follow the letter of the law and don't get tricky. Paying the bonus after yearend can be a great way to secure a deduction for the year while preserving the cash for 2-1/2 months. But failure to reduce the plan to writing and following through will void the benefits.

--Last Update 11/14/11