Service Issues Favorable Ruling Permitting Satisfaction of the "All Events Test" for Accrual Method Taxpayer For Bonus Obligations Where Identity of Recipient and Amount of Bonus Not Yet Determined
Background
Taxpayers using the accrual method of income are required to recognize gross income in the taxable year in which “all the events which have occurred which fix the right to receive such income and the amount….can be determined with reasonable accuracy”. Treas.Reg. § 1.451-1(a). Deductions are allowed to the accrual method taxpayer when “all the events have occurred which determine the fact of the liability,” the amount of the deductible item “can be determined with reasonable accuracy,” and economic performance has occurred with respect to the item. § 461(h); Treas. Reg. § 1.461-1(a)(2); Prop. Reg. § 1.461-1(a)(2). See U.S. v. Anderson, 269 US 422, 440–41 (1926)(adopted the “all events test” for accruing expenditures); Spring City Foundry Co. v. Comm’r, 292 U.S. 182, 184-185 (1934). Where an expenditure results in the creation of an asset whose tax life extends substantially beyond the close of the taxpayer year must be capitalized. Treas. Reg. § 1.461-1(a)(2).
Treas. Reg. §1.461-1(a)(2)(i) provides that, under an accrual method of accounting, a liability is incurred, and is generally taken into account for federal income tax purposes, in the taxable year in which: (i) all the events have occurred that establish the fact of the liability; (ii) the amount of the liability can be determined with reasonable accuracy, and (iii) economic performance has occurred for the liability (collectively, the “ all events test”). See also Treas. Reg. § 1.446-1(c)(1)(ii)(A).
Exceptions to strict application of the “all events test” have been carved into various portions of the Internal Revenue Code and set by case law. For example, payments for goods and services to be supplied in future years are generally included in gross income under the accrual method when received and not when earned. Deductions are generally not allowed for estimates of costs of meeting contractual obligations under current sales or repair contracts. Special statutory rules injecting cash basis principles onto accrual method accounting taxpayers are applicable for charitable donations, medical expenses, contributions to qualified pension and profit sharing plans. In such instances the deduction is granted when paid and not when the liability to pay arises. See §§ 170(a)(1) (charitable contribution deduction); 213(a)(medical expenses “paid”), 404(a)(profit sharing and pension plans).
Application to Year End Bonuses
Where an accrual method taxpayer is obligated to pay a fixed amount of bonuses to a group of employees at the end of tax year in when the services were rendered but does not know either the particular recipients who will receive the bonuses or the amount each such service provider will receive until after the end of the tax year, the question arises as to whether such uncertainties prevent the accrual of such bonuses at the end of the current year.
In Rev. Rul. 76-345, 1976-2 C.B. 134, the Service announced that it would not follow the decision reached by the United States Court of Claims in Washington Post Company v. U.S., 405 F.2d 1279 (1969) that an accrual method taxpayer may deduct the full amount under a profit sharing plan established for its independent circulation dealers, for which its liability is fixed and certain with respect to the group as a whole, but for which the ultimate recipients, the time of actual payout, and the amount payable to each recipient cannot be ascertained in the year of accrual. In the Service’s view the “fact of the liability” under the first prong of the “all events test” is left unsatisfied where the identity of the recipient or the amount of the bonus payable to each is not determinable until after the end of the tax year.
In Rev. Rul. 2011-29, 2011-49 IRB (11/9/2011) the Service reached the opposite conclusion and announced it was revoking Rev. Rul. 76-345, supra. This should help facilitate the expensing of year end incentive bonuses without having to finalize the service providers entitled to receive bonuses or the amounts of the bonuses before year end.
Ruling Facts
As set forth in the Ruling, the taxpayer used the accrual method and pays bonuses to a group of employees under a bonus plan for services rendered during the current tax year. The minimum total amount of the bonuses under the program is determined: (i) by formula that is fixed prior to the end of the taxpayer year taking into account financial information of the company’s operations as of the end of the year; or (ii) by corporate action, such as a resolution of the board of directors or compensation committee made prior to the end of the year. Such action fixes the bonuses payable to the entire group. Bonuses are paid after the end of the taxable year but within 75 days of the succeeding year. If the employee entitled to the bonus is not working with the company at the time paid, the bonus is forfeited. Therefore, any forfeiture of the minimum total amount of the bonus is reallocated.
Under the first prong of the all events test an accrual method taxpayer must establish that “all events” have occurred which establish the fact of the liability. See Rev. Ruls. 2007-3, 2007-1 C.B. 350; 80-230, 1980-2 C.B. 169; Rev. Rul. 79-41-, 1979-2 C.B. 213, amplified by Rev. Rul. 2003-90, 2003-2 C.B 353. While an expense may be deductible before it is due and payable it is required that liability for the expense must first be firmly established. See, e.g., U.S. v. General Dynamics Corp., 481 U.S. 239, 243 (1987).
As mentioned, Rev. Rul. 76-345, supra, expressed disagreement with the holding in the Washington Post case issued by the U.S. Court of Claims that the first prong of the all events test may be met where the total amount of the liability was fixed at the end of the taxable year.
Holding By Service
Similar to the holding in Washington Post was the Supreme Court’s decision in U.S. v. Hughes Properties, Inc., 476 U.S. 593 (1986) that permitted a casino operator to deduct amounts guaranteed for payments to be made on slot machine jackpots that were not yet won by patrons by the end of the tax year. Critical to the Court was the that that a fixed obligation to pay was present regardless of which particular patron won. 476 U.S. @602. Therefore, in Rev. Rul. 2011-29, supra, the Service agreed that the liability for the taxpayer’s minimum amount of bonuses was established by the end of the year in which the services were rendered. This fact of liability satisfied the first prong of the all events test under Treas. Reg. 1.461-1(a)(2)(i).
The Ruling ends by declaring that accrual method taxpayers changing their prior practice on the treatment of bonuses to obtain the benefits of Rev. Rul. 2011-29 are instituting a change of accounting method that must meet the requirements of §§446 and 481 and applicable administrative procedures. See Rev. Proc. 2011-14, 2011-4 I.R.B. 330, §19.01(2).
