Payroll taxes on bonuses and vacation pay

Recurring item deduction exception allowed for payroll taxes on bonuses and vacation pay

Mike Habib, EA

myIRSTaxRelief.com

In a Revenue Procedure, IRS has provided a safe harbor accounting method for accrual method taxpayers that incur Federal Insurance Contributions Act (FICA) tax and Federal Unemployment Tax Act (FUTA) tax (i.e., payroll tax) liabilities bonuses and vacation pay, as well as other compensation. Under the safe harbor, a taxpayer may be treated as satisfying the requirements for the recurring item exception in Reg. § 1.461-5(b)(1)(i) for its payroll tax liability in the same tax year in which all events have occurred that establish the fact of the compensation liability and the amount of the compensation liability can be determined with reasonable accuracy. Procedures are provided for taxpayers to obtain automatic IRS consent to change to this accounting method.

Background. Under Code Sec. 461(a), a deduction or credit must be taken for the tax year that is the proper tax year under the taxpayer’s method of accounting used to compute its taxable income. 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 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 with respect to the liability (the “all events test”).

Under the recurring item exception to the general rule of economic performance, a liability is treated as incurred for a tax year if:

  • 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 accuracy (Reg. § 1.461-5(b)(1)(i));
  • 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 (Reg. § 1.461-5(b)(1)(ii));
  • the liability is recurring in nature (Reg. § 1.461-5(b)(1)(iii)); and
  • 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. (Reg. § 1.461-5(b)(1)(iv))

For many years, IRS’s position was that FICA and FUTA taxes for accrual method taxpayers were incurred only in the tax year the compensation giving rise to the payroll tax liability was paid. However, IRS conceded the issue of deductibility of payroll taxes for year-end wages after the Court of Claims held in Eastman Kodak Co v. U.S., (Ct Cl 1976) 37 AFTR 2d 76-1200, that an accrual employer could deduct its share of FICA and FUTA on year-end wages in the year they were accrued, rather than in the following year when they were paid. (Rev Rul 96-51, 1996-2 CB 36, Rev Rul 2007-12, 2007-11 IRB 685, see Federal Taxes Weekly Alert 02/22/2007) However, the court in Eastman Kodak also held that the fact of the liability for payroll taxes on bonuses and vacation pay was not established in Year 1 because of the uncertainty at the end of Year 1 as to whether the employee will reach the payroll tax ceiling at the time of payment in Year 2.

Recognizing that the proper accrual of FICA and FUTA tax liabilities continues to be an area of uncertainty for taxpayers, IRS has provided a safe harbor for reasons of administrative convenience and to reduce further controversy.

Safe harbor accounting method. Rev Proc 2008-25 provides that solely for purposes of the recurring item exception in Reg. § 1.461-5, a taxpayer will be treated as satisfying the requirement for the recurring item exception in Reg. § 1.461-5(b)(1)(i) for its payroll tax liability in the same tax year in which all events have occurred that establish the fact of the related compensation liability and the amount of the related compensation liability can be determined with reasonable accuracy. Rev Proc 2008-25 doesn’t apply to an employee’s portion of FICA tax imposed under Code Sec. 3101 and deducted by the employer from wages paid to the employee.

    Illustration: Calendar year X uses an accrual accounting method, including the recurring item exception. X properly changes to the Rev Proc 2008-25 safe harbor for its payroll tax liabilities. During Year 1, X’s employee A earns $10,000 of vested vacation compensation for services performed during Year 1. X pays the vacation compensation to A in February and May of Year 2. Assume that, as of Dec. 31 of Year 1, all events have occurred to establish the fact of X’s vested vacation compensation liability and the amount of the liability is determinable with reasonable accuracy. Solely in applying the recurring item exception, all events necessary to establish the fact of the payroll tax liability for the $10,000 vested vacation compensation incurred by X will be treated as having occurred in Year 1, and the amount of the payroll tax liability will be treated as being determined with reasonable accuracy in Year 1.

Illustration: Calendar year Y uses an accrual accounting method, including the recurring item exception. Y properly changes to the Rev Proc 2008-25 safe harbor for its payroll tax liabilities. On Dec. 28 of Year 1, Y’s board of directors approves a bonus pool of $1,000,000 to be paid to Y’s employees for services provided during Year 1. The $1,000,000 bonuses are paid to Y’s employees on Jan. 5 of Year 2. Assume that, as of Dec. 31 of Year 1, all events have occurred to establish the fact of the bonus compensation liability and the amount of the liability is determinable with reasonable accuracy. Solely in applying the recurring item exception, all events necessary to establish the fact of the payroll tax liability for the $1,000,000 in bonuses incurred by Y will be treated as having occurred in Year 1, and the amount of the payroll tax liability will be treated as being determined with reasonable accuracy in Year 1.

Observation: Thus, taxpayers X & Y in Illustration 1 & 2 will be able to deduct their respective vacation pay and bonus compensation liability in Year 1. A taxpayer within the scope of Rev Proc 2008-25 that wants to change its treatment of payroll tax liabilities to conform to the safe harbor method of accounting (including a change to use the recurring item exception for payroll tax liabilities) must follow the automatic change in accounting method provisions of Rev Proc 2002-9, 2002-1 CB 327, with the modifications specified in Rev Proc 2008-25, Sec. 5.

Effective date. Rev Proc 2008-25 is effective for tax years ending on or after Dec. 31, 2007. IRS will not challenge a taxpayer’s use of the safe harbor method on a return filed before Mar. 11, 2008, if the taxpayer meets the requirements of Rev Proc 2008-25 in that tax year. If the taxpayer’s use of the safe harbor method on a return filed before Mar. 11, 2008, is an issue under consideration in examination, appeals, or before a federal court, IRS will not further pursued the issue. Reg. §1.461-5(b)(1)(i)

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