You may be familiar with the tax rule allowing a company to deduct employee bonuses this year as long as it pays them within 2.5 months of the end of the tax year. This appealing year-end planning strategy is advantageous to both your company and your staff: your employees do not have to disclose their income until the next year, and you benefit from a tax credit this year.
But these tax benefits aren’t always available, so it’s critical to understand what is required to deduct employee bonuses this year. Here’s a brief recap.
Only accrual-basis taxpayers; no related parties
Bonuses must be deducted in the year they are paid, even if they were earned in the year prior, if your company utilizes the cash method of accounting. In order to accelerate bonus deductions into the current year, your company needs to be using the accrual method of accounting.
Tax benefits are only available for bonuses given to unrelated parties. A person who owns more than 50% of a corporation is considered to be a related party for a corporation. Any of the shareholders, partners, or members of S corporations, limited liability companies, and partnerships are considered related parties.
Both fixed and determinable
You cannot deduct a bonus this year unless it is fixed and determinable as of December 31, even if the first two requirements are satisfied. In general, this means that:
- The recipient has earned the bonus.
- Everything that is necessary to prove the company’s obligation to pay it has happened, and
- It is possible to calculate the bonus amount with reasonable accuracy.
The “fixed and determinable” clause trips up a lot of businesses since their bonus programs tie payment to the employee’s continuous employment through the payment date. The company’s liability isn’t determined by year-end if employees quit before the payout date and forfeit their incentives.
But perhaps there’s a way around this issue. Bonuses earned this year may be deducted under IRS instructions, even if there is a chance of forfeiture. The use of a well-designed bonus pool may be the answer. The aggregate amount in the pool needs to be fixed before the year’s end for this technique to work. Furthermore, any employee bonuses that are forfeited must be divided among the remaining staff members.
Deduct Employee Bonuses with caution
Make sure you meet the standards before deducting employee bonuses this year. It’s imperative that you carefully craft your incentive plan to eliminate any language that implies bonuses won’t be settled by year’s end, including keeping the ability to change or cancel them or requiring board approval before payment can be made. Consult with one of our tax experts if you have questions about deducting employee bonuses.