Accrued taxes: new IRS advice may accelerate payroll tax deductions.

IRS Field Attorney Advice 20061701F, (April 28, 2006), which may not be used or cited as precedent, considered whether accrual basis taxpayers can deduct employment taxes on vacation/bonus pay accrued at year-end, but not paid until the next year.

Facts

An accrual method taxpayer currently deducts payroll taxes on year-end accrued vacation and bonus pay in the year before these taxes or the related compensation are paid.

Conclusion

Accrual method taxpayers may be allowed to deduct employment taxes on vacation/bonus pay accrued at year-end but not paid until the subsequent year. But these taxpayers must satisfy IRC Sec. 461(h)(3) and Regs. Sec. 1.461-1(a)(2)(i).

Discussion

Under the accrual method, a liability is incurred and is generally taken into account in the year in which: 1) all the events have occurred, establishing the fact of the liability; 2) the amount of the liability can be determined with reasonable accuracy; and 3) economic performance has occurred with respect to the liability [Regs. Sec. 1.461-1(a)(2)(i)]. Combined, the first two requirements are called the "all events test" [Sec. 461(h)(4)].

Sec. 461(h)(1) provides that, in determining whether an amount has been incurred with respect to any item during any tax year, the all events test shall not be treated as met any earlier than when economic performance with respect to such item occurs. Regs. Sec. 1.461-4(g)(6) provides that economic performance occurs as a tax is paid to the governmental authority that imposed it.

Sec. 461(h)(3) and Regs. Sec. 1.461-5 provide the recurring item exception to the economic performance rule. Under this exception, a liability is treated as incurred for a year if:

1) At year-end, all events have occurred establishing the fact of the liability and the amount can be determined with reasonable accuracy;

2) Economic performance occurs on or before the earlier of (a) when the taxpayer timely files a return or (b) the 15th day of the ninth calendar month after the year-end;

3) The liability is recurring in nature and the taxpayer consistently treats the item as incurred in years where the all events test is met; and

4) Either the liability's amount is not material or the liability's accrual in the earlier year results in better matching of the liability against the related income. In the case of a tax liability, this matching requirement is deemed satisfied [Regs. Sec. 1.461-5(b)(5)(ii)].

Under Rev. Rul. 69-587 and Eastman Kodak [209 Ct.Cl. 365 (1976), Acq. 1996-2 CB 1], employment taxes on accrued bonuses and vacation pay of an accrual method taxpayer are deductible in the year in which they are paid rather than the year the vacation/bonus pay is accrued.

Thus, for a taxpayer to currently deduct employment taxes on accrued vacation/bonus pay that is paid in the subsequent year, it must meet the all events test and economic performance must have occurred with respect to the liability. Both Rev. Rul. 69-587 and Eastman Kodak predate the effective date of the recurring item exception.

The adoption of the recurring item exception, together with the holdings in Rev. Rul. 69-587 and Eastman Kodak, provide a framework for determining whether the taxpayer, in the instant case, can deduct the employment taxes related to the accrued vacation and bonus pay if it establishes certain elements.

Applying the Recurring Item Exception

The taxpayer must establish these facts before being allowed to currently deduct employment taxes related to vacation/bonus pay accrued at year-end but not paid until the subsequent year:

1) The liability for each type of year-end compensation (to which the employment taxes relate) is fixed and its amount can be determined with reasonable accuracy (satisfying the all events test). An analysis of this factor requires a detailed examination of the taxpayer's bonus and vacation plans to ascertain its method for determining the employees' entitlement to the accrued bonus or vacation pay.

Under the respective plans, the liability for the year-end compensation must be fixed and the amount must be determined with reasonable accuracy (e.g., a bonus based on a percentage of year-end sales where the sales are known at year-end);

2) The accrued deduction for employment taxes must be limited to the taxes for year-end compensation (meeting the all events test) paid within 2.5 months of year-end;

3) The taxpayer adopts the recurring item exception by consistently treating the item (which must be recurring in nature) as incurred in the years the all events test is met; and

4) The taxpayer must not deduct any payroll taxes with respect to any employee whose pay could exceed the wage caps at the time the accrued wages are paid (i.e., within the 2.5 months after the year-end). This usually will be limited to highly compensated employees because of the current wage cap.

If these facts are established, the taxpayer may be allowed to deduct employment taxes on vacation/bonus pay accrued at year-end, but not paid until the subsequent year.

Stuart R. Josephs, CPA has a San Diego-based Tax Assistance Practice (TAP) that specializes in assisting practitioners in resolving their clients' tax questions and problems. Josephs, chair of the Federal Subcommittee of CalCPA's Committee on Taxation, can be reached at [phone] or [e-mail].

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By Stuart R. Josephs, CPA