Clients should pay their bills on time or risk deferring the deduction.

Accrual-basis taxpayers that delay the payment of accrued liabilities for compensation to independent contractors (e.g., accountants, lawyers, repair service people, computer programmers) beyond 2 1/2 months may find that the deduction will not be allowed until a tax year following the year of accrual. This results from the interaction of Regs. Sec. 1.461l1[a][2], Sec. 404{d} and Sec. 4041b1.

Generally, when services are performed before year-end for an accrual-basis taxpayer, an accrual for the related fees for compensation] generally can be made at year-end. Regs. Sec. 1.461-1[a][2] allows a liability to be accrued at such time as the liability is considered incurred. A liability is considered incurred in the tax year in which all the events establishing the fact of the liability have occurred, the amount of the liability is determinable with reasonable accuracy, and economic performance has occurred with respect to the liability. Economic performance with respect to a liability arising out of the provision of services to a taxpayer occurs when the services are provided [Regs. Sec. 1.461-4[d].

Although compensation expense may be properly accrued under Regs. Sec. 1.461-4[d], Sec. 404[d] will govern the time for deduction of compensation incurred by a taxpayer under a plan, method or arrangement deferring its receipt by service providers for services for which there is no employer-employee relationship. Accordingly, compensation expense incurred under such circumstances is not deductible until the amount is includible in the gross income of the service provider. Temp. Regs. Sec. 1.404[d]-lT states that Sec. 404(a) and (b)both directed at employer-employee relationships--and the regulations thereunder apply as if the person providing the services was the employee and the person to whom the services are provided was the employer.

Compensation expense accrued at year-end and received later than 2 1/2 months after year-end by an employee [or a service provider as provided under Temp. Regs. Sec. 1.404[d]J-lT] is presumed to be pursuant to a plan, method or arrangement deferring the receipt of compensation [Temp. Regs. Sec. 1.404[b]-IT). This determination is made separately for each service provider and the presumption of the existence of a plan, method or arrangement is rebuttable.

To rebut this presumption, a taxpayer must show that it is impracticable, either administratively or economically, to avoid the receipt of the compensation by the service provider after 2 1/2 months beyond year-end and that such impracticability was unforeseeable at year-end. Such a case would exist if, for example, a taxpayer could not make payment within the 2 1/2-month period because it would jeopardize the taxpayer's solvency and such circumstance was not foreseeable at year-end [Temp. Regs. Sec. 1.404[b]-IT].

A recent Tax Court decision demonstrates the application of both the impracticability and unforeseeable requirements. In National Medical Financial Services, Inc., TC Memo 1992-178, an accrual-basis corporation accrued bonuses as of Dec. 31, 1986 for its two unrelated 50% owner-employees. The bonuses were never paid. The IRS disallowed the deduction for the bonuses under Temp. Regs. Sec. 1.404(b)-IT because the bonuses were not paid within 2 1/2 months after year-end. Therefore a plan, method or arrangement deferring the receipt of the compensation was presumed to exist. It was the taxpayer's responsibility to rebut this presumption.

The taxpayer was in the business of renting and selling medical equipment to doctors and home care patients. A large portion of its income was from Medicare and Medicaid payments. Payment was delayed sometimes up to five or six months after the service was performed. In March and April 1987, the taxpayer deposited cash funds into an escrow account to purchase a blood and medical testing lab. The taxpayer had initially become interested in the business in 1985, started to negotiate the purchase in the middle of 1986, and infused cash into the business shortly after its acquisition. Additionally, the taxpayer used some of the cash to make numerous regular investments in stocks beginning in December 1986 and continuing through 1990.

The taxpayer argued that good business judgment required the retention of cash and liquid investments. The acquired business required unforeseeable amounts of cash and at times resulted in the taxpayer being technically insolvent. Furthermore, payments were slow in coming from Medicare and Medicaid. The taxpayer argued that paying the bonuses would have caused greater insolvency.

The IRS, in turn, argued that the taxpayer could have paid the bonuses if it had so desired, since it had substantial cash and investment balances at Dec. 31, 1986. It was the taxpayer's choice to make additional investments and conserve cash in anticipation of purchasing the blood and medical lab.

The Tax Court concluded that the taxpayer could have chosen to pay the bonuses rather than the other items, and did not demonstrate that paying the bonuses was impracticable. Furthermore, the court stated that the late payments from Medicare and Medicaid were not unforeseeable {nor was the cash investment into the blood and medical testing lab).

Accrual-basis taxpayers that have made an accrual for compensation to independent contractors at year-end would be well advised to review their cash flow projections to make sure that such amount can be paid within 2 1/2 months. The cash flow projections presumably should take into account expected business conditions and expected uses of cash. If it becomes evident that cash will be tight and that the compensation may not be paid within the 2 1/2-month period, the taxpayer may want to give a higher priority to payment of the accrued compensation or consider dipping into the credit line to make payment. Otherwise, nonpayment of the accrued compensation within the 2 1/2-month period could result in the disallowance of the deductions, unless, of course, the taxpayer can prove that it was impracticable to pay the bonuses or that the cash flow shortages were unforeseeable.

From Stephen G. Kafka, CPA, Los Angeles, Cal.