Businesses with annual employee bonus plans have long operated under the assumption that as long as they pay bonuses within 2 ½ months after the end of the year in which the bonuses are earned, the bonuses are deductible in the year earned, rather than in the year paid.

1. 1 | P a g e
May 2014
IRS Continues to Attack Accrued Bonus Plans
Businesses with annual employee bonus plans have long operated under the assumption that as long as they
pay bonuses within 2 ½ months after the end of the year in which the bonuses are earned, the bonuses are
deductible in the year earned, rather than in the year paid. While it is true that the “2 ½ month rule” must be
satisfied in order to deduct the bonus in the year earned, other requirements must be met as well. The IRS
has issued several rulings in the last few years illustrating how many bonus plans may fail these requirements.
While these rulings may cast doubt upon the deductibility of many employers’ current bonus plans, they also
shed light on how to structure a bonus plan to withstand IRS scrutiny.
For taxpayers using the accrual method of accounting, a liability generally is deductible under the "all-events
test" in the taxable year in which:
• All events have occurred that establish the fact of the liability,
• The amount of the liability can be determined with reasonable accuracy, and
• Economic performance has occurred with respect to the liability.
Economic performance with respect to compensation generally occurs when the services creating the right to
the compensation are performed. Compensation paid to an employee more than 2 ½ months after the end of
the employer's tax year, however, is not deductible until the year it is paid. Employers have been lured into a
false sense of security, believing that any compensation paid within 2 ½ months of year end for services
provided in the prior year was deductible in the year the services were provided.
As we discussed in last September’s InTouch article, “Nuances of Bonus Program Impact Timing of
Deduction”, the IRS has issued a series of rulings illustrating situations where bonuses were not deductible
until the year in which they were paid because the fact of the liability had not become fixed by year end. Some
of the lessons learned from these rulings include:
If a bonus plan requires that employees still be employed by the taxpayer on the date that bonuses
were paid in order to receive that compensation, and any unpaid bonuses by virtue of an employee’s
termination of employment revert back to the employer, then no employee bonuses are deductible until
the year paid since the bonus liability is subject to a contingency and is not fixed by year end. [CCA
200949040]
If the aggregate amount of bonuses to be paid becomes fixed by year end via a formula or some other
corporate action, and any forfeited bonuses due to an employee’s termination of employment are
reallocated among other eligible employees, then bonuses paid within 2 ½ months of the employer’s
year end are deductible in the year the services were rendered. [Rev. Rul. 2011-29]

2. 2 | P a g e
Even when an aggregate bonus is accrued at year end pursuant to a formula based on company
performance metrics, and bonuses allocable to terminated employees are reallocated to other eligible
employees if they terminated between year end and when the section managers finalize the individual
bonus awards, the bonuses are not deductible until the year paid if bonuses allocable to employees
who terminate after the section managers finalize the awards but before the bonuses are paid revert
back to the employer. [CCA 201246029]
Last fall, the IRS’s LB&I Division released FAA 20134301F which digs even further into the nuances of
employee bonus plans and how easily they can fail to establish a fixed liability by year end, thus delaying the
deduction for the bonuses until the year in which they are paid. The bonus plans discussed in this ruling were
largely formula driven, yet each of them was subject to some action after year end that caused them to fail the
“all-events test”:”
Reservation of Right to Modify or Cancel Bonuses – Even if a bonus plan contains a fixed formula
for determining the amount of employee bonuses, if under the bonus plan the employer reserves the
right to unilaterally modify or cancel the bonuses prior to payment, the employer has no legal obligation
to pay the bonuses and, thus, they are not deductible until actually paid to the employees.
Required Approval of Bonuses – Even if an employee bonus plan is based on numerical targets that
are established during the year in which the services are performed, if the calculated bonuses still must
be approved by the board of directors or a compensation committee before they can be paid, and that
approval does not take place until after year end, the bonuses are not deductible until they are paid.
The IRS concluded that since the board or committee already approved the numerical targets used in
the bonus computations, the fact that they still must approve the bonuses themselves before they can
be paid suggests that the approval is not a mere formality or ministerial act.
Bonuses Based on Performance Appraisals – If some portion of the pre-established bonus formula
is based on the employees’ individual performance scores, and those performance scores are based
on individual performance appraisals that are not completed until after year end, then the fact of the
liability has not been established by year end (because a performance score of zero would yield a
bonus of zero), nor has the amount of the liability been determined by year end.
Accrual basis businesses with employee bonus plans should review those plans in detail to determine whether
any elements of those plans subject the obligation to pay, or the amount of the bonuses, to events that take
place after year end. Bonus plans and the related practices may need to be modified to ensure the
deductibility of those bonuses in the year the services are performed. If your company has a bonus plan or
accrues any compensation to its employees at year end, consult your local CBIZ MHM tax advisor to discuss
the nuances of your plan and whether the requirements for deducting the accrued liability are being satisfied.

3. 3 | P a g e
Copyright © 2014, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without
the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we
inform you that—unless specifically indicated otherwise—any tax advice in this communication is not written
with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue
Code, or to promote, market, or recommend to another person any tax related matter. This publication is
distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice.
The reader is advised to contact a tax professional prior to taking any action based upon this information.
CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no
obligation to inform the reader of any changes in tax laws or other factors that could affect the information
contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC and other Financial Services subsidiaries of CBIZ, Inc.
(NYSE: CBZ) that provide tax, financial advisory and consulting services to individuals, tax-exempt
organizations and a wide range of publicly-traded and privately-held companies.