Deduct Employee Bonuses in the Previous Tax Year

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There is a tax rule that permits your business to deduct employee bonuses in the previous tax year if bonuses are paid within 2½ months after the end of that tax year. The business gets a needed tax deduction now and your employees don’t need to report the income until the following tax year.

This option isn’t available to every business or in every case. There are rules regarding your accounting method as well as the terms of the bonuses given. Here is a quick summary. See if these factors relate to your business by contacting your small business tax services leader at LvHJ.

What is your accounting method?

If your business uses the cash method of accounting, you must deduct bonuses in the year they are paid, even if they were earned in the previous tax year. To accelerate bonus deductions into the previous tax year, your business must be on the accrual method of accounting.

Who is getting the bonus and how?

If your business is using the accrual method of accounting, that is requirement one. Here are the others.

Unrelated parties – This tax planning option is limited to bonuses paid to unrelated parties. For a corporation, an unrelated party is an individual who owns less than 50% of the company. For S corporations, partnerships and limited liability companies, unrelated parties include employees and individuals who are not shareholders, partners or members.

Fixed and determinable – The bonus must also be fixed and determinable as of December 31 of the tax year in which you want to deduct the bonuses. Generally, this means that:

  • The recipient has earned the bonus,
  • All events have taken place that establish the company’s liability to pay it, and
  • The amount of the bonus can be determined with reasonable accuracy.

Many companies don’t meet the “fixed and determinable” requirement because their bonus plans condition payment on the recipient’s continued employment through the payment date. If employees leave the company before the payment date and forfeit their bonuses, the company’s liability isn’t established by year end.

Under IRS guidance, it is still possible to deduct bonuses even with a risk of forfeiture. By using a properly designed bonus pool, the aggregate amount in the pool is fixed by the end of the year and any forfeited bonuses must be reallocated among the remaining employees in the bonus pool.

Accelerating bonus deductions is an effective strategic tax planning strategy if your business has designed a proper bonus plan. Keep in mind that the employer cannot retain discretion to modify or cancel a bonus or condition bonus payments on board approvals. Such factors may impact tax compliance for accelerated bonus deductions. Again, if you have any questions, contact our small business tax services team at LvHJ.

Next: 5 Small Business Tax Impact Reduction Ideas

Source: Checkpoint Marketing

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