The IRS has recently targeted accrued bonuses in its examinations. Accrued bonuses have been disallowed if payment is contingent upon the employee remaining employed at the time of payment in the following year, with the bonus being forfeited back to the company if the employee leaves prior to payment.

Generally, for accrual basis taxpayers an accrued bonus is deducted in the current year if it was earned by year-end and paid within the first two and a half months of the following year. The IRS's position is that the "All Events Test" is not met with regard to the stipulation that the employee must remain employed at the date of payment. This is forcing many taxpayers to implement or revise their bonus plans or file accounting method changes for previous year audit protection. If changes are not made to company plans, significant deferral of year-end bonus deductions could occur.

For an accrual basis-taxpayer to deduct accrued bonuses, the following four conditions must be met:

1. All events must have occurred to establish the fact of the liability by year-end;
2. The amount of the liability must be determinable with reasonable accuracy by year-end;
3. Economic performance must occur by year-end; and
4. Payment must be made within 2 ½ months of year-end.

The IRS has emphasized that employers must consider the elimination of any risk of forfeiture of the accrued bonuses to ensure meeting condition 1 above.

To avoid losing a deduction for accrued bonuses, it is recommended to formalize and document the policy for payment and deduction of bonuses. The recommendation is to include in the policy an indication that the bonus will be paid to employees employed with the company on the date that bonus amount is determined or on the last day of the tax year.

If your company does not wish to pay employees terminated prior to the date of the bonus payment, a plan could be written to pay the entire amount calculated for the bonus and reallocate any forfeited amounts to the others still employed on the date of payment. Another option is to authorize a minimum bonus pool prior to year end in an amount that is reasonably expected to be paid to qualifying employees.