Accrued payroll tax liability is deductible even if compensation is deferred under Sec. 404.

A recent ruling states that accrual-method taxpayers may deduct payroll tax liability incurred in the current year, for compensation deferred and deductible in the following year, under Sec. 404, provided the all-events test and recurring-item exception of Sec. 461 are met.

Facts

X, a corporation, uses an accrual method of accounting and files its Federal income tax returns on a calendar-year basis. As of the end of year 1,X has a fixed liability to pay compensation for services provided by its employees during year 1. As of the end of that year, all events have occurred to establish X's liability for the taxes owed under Secs. 3111 (the employer's share of FICA taxes) and 3301 (FUTA taxes) and the amount of the payroll tax liability can be determined with reasonable accuracy. X properly adopted the recurring-item exception under Regs. Sec. 1.461-5 as a method of accounting for the payroll taxes. X pays the payroll taxes either (1) in year 1 or (2) before the earlier of September 15 of year 2 or the date X files a timely (including extensions) Federal income tax return for year 1. Thus, under Sec. 461, the payroll taxes generally would be treated as incurred by X in year 1. However, the compensation to which the payroll taxes relate is deferred compensation properly deductible under Sec. 404 in year 2.

Sec. 404

In general, compensation is deductible under Sec. 404 if it is paid or accrued under a deferred-compensation plan. However, an employer's payroll tax liability is not compensation. Thus, Sec. 404 does not control the deductibility of X's payroll tax liability, even though it relates to a deferred-compensation liability subject to Sec. 404, nor does it alter the timing of the accrual of such payroll tax liability under Sec. 461.

Sec. 461

Regs. Sec. 1.461-1(a)(2)(i) provides that, under the accrual method, a liability is incurred, and generally taken into account for Federal income tax purposes, in the tax year in which (1) all the events have occurred that establish the fact of the liability, (2) the amount of the liability can be determined with reasonable accuracy and (3) economic performance has occurred as to the liability (the all-events test).

For a payroll tax liability, Kegs. Sec. 1.461-4(g)(6) provides generally that economic performance occurs as the tax is paid to the governmental authority that imposed it. However, Regs. Sec. 1.461-5(b)(1) provides a recurring-item exception to the general rule of economic performance. Under that exception, a liability is treated as incurred for a tax year if (1) at the end of the tax year, all events have occurred that establish the fact of the liability and the amount can be determined with reasonable accrual; (2) economic performance occurs on or before the earlier of (i) the date that the taxpayer files a return (including extensions) for the tax year or (ii) the 15th day of the ninth calendar month after the close of the tax year; (3) the liability is recurring in nature; and (4) either the amount of the liability is not material or accrual of the liability in the tax year results in better matching of the liability against the income to which it relates than would result from accrual of the liability in the tax year in which economic performance occurs. Under Kegs. Sec. 1.461-5(b)(5)(ii), the matching requirement of the recurring-item exception is deemed satisfied in the case of tax liability.

Prior Rulings

Rev. Rul. 69-587, 1969-2 CB 108, concluded that, under the all-events test of Sec. 461, an accrual-method employer generally may not deduct payroll taxes payable for bonuses and vacation pay accrued, but unpaid, at year end until the tax year in which they are paid.

Rev. Rul. 96-51, 1996-2 CB 36, held that, under the all-events test, an accrual-method employer may deduct in year 1 its payroll taxes for year-end wages properly accrued in year 1, but paid in year 2, provided the employer satisfies the requirements of the recurring-item exception in Regs. Sec. 1.461-5. However, Rev. Rul. 96-51 did not address the application of Sec. 404, because the year-end wages were paid before the 15th day of the third calendar month after the end of year 1.

Holding

Rev. Rul. 69-587 is revoked and Rev. Rul. 96-51 is amplified. An accrual-basis taxpayer may treat its payroll tax liability as incurred in year 1, even if the compensation is deferred compensation deductible in year 2, under Sec. 404, provided the all-events test and recurring-item exception of Sec. 461 are met. Rev. Rul. 2007-12, IRB 2007-11

David O'Driscoll, J.D., LL.M.