The deductibility of year-end compensation accruals varies by the type of business and the relationship of the worker to the business. The general rules for deduction are:
- Shareholders of S corporations (regardless of percentage interest owned) – Compensation accruals, including vacation pay and holiday pay, are not deductible.
- Partners and LLC members (regardless of percentage interest owned) - Compensation accruals, including vacation pay and holiday pay but not including guaranteed payments determined without regard to the income of the partnership, are not deductible.
- More-than-50%-owners of C corporations - Compensation accruals, including vacation pay and holiday pay, are not deductible.
- All other employees - Compensation accruals are deductible if the following tests are met:
- All the events that fix the liability have occurred;
- The liability is determinable with reasonable accuracy; and
- The accruals are paid within two and a half months after year-end.
The second and third tests above are fairly straightforward and typically do not present problems. However, the all-events test does have some technical requirements associated with it. Here are the general rules for the all-events test to be met:
- The total amount of the bonus pool must be determined before year-end. (The actual allocation by employee can be done after year-end.)
- No amounts can revert back to the employer. For example, if an employee leaves before payment is made and his or her bonus is not allocated to the other employees in the bonus pool, the entire year-end accrual will not be deductible.
- If the accrual is subject to review and approval by a board of directors or some other committee, that approval process must occur before year-end in order for the accrual to be deductible.
Please contact your Wipfli relationship executive if you have any questions regarding whether your bonus plan meets these tests.