Year-End Tax Planning: Maximizing Tax Benefits from Employee Bonuses

Business owners may be familiar with the rule that permits a business to deduct employee bonuses this year if the bonus is paid within 2.5 months after the end of the tax year. It’s an attractive year-end planning technique that benefits your business and your employees. Business owners enjoy a tax deduction this year, while your employees don’t need to report the income until next year.

Business owners must meet certain requirements to qualify for the deduction, so it’s important to understand the qualification criteria.

Accrual-basis taxpayers only; no related parties

If your business uses the cash method of accounting, bonuses must be deducted in the year they’re paid, even if they’re earned in the previous year. To accelerate bonus deductions into this year, your business must be on the accrual method of accounting.

Favorable tax treatment is limited to bonuses paid to unrelated parties. For a corporation, a related party is an individual who owns more than 50% of the company. For S corporations, partnerships and limited liability companies, related parties include any of their shareholders, partners or members.

Fixed and determinable

Even if the first two requirements are met, you can’t deduct a bonus this year unless it’s fixed and determinable as of December 31. 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 get tripped up by the “fixed and determinable” requirement because their bonus plans conditional payment on the recipient’s continued employment through the payment date. If employees who leave the company before the payment date forfeit their bonuses, the company’s liability isn’t established by year-end.

There may be a way to avoid this problem. Under IRS guidance, businesses may deduct bonuses earned this year, even if there’s a risk of forfeiture. The solution can be to use a properly designed bonus pool. The designed bonus pool strategy only works if 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.

Handle with care

If you wish to accelerate deductions for bonuses paid next year, consult your trusted tax professional to make sure that you meet the requirements. It’s critical to design your bonus plan carefully to avoid any language that suggests bonuses aren’t fixed by the end of the year, such as retaining discretion to modify or cancel them or conditioning payment on board approval. Fill out the form on this page to connect with a member of our tax practice.

For more year-end tax planning ideas, view our tax planning guide.

10/25/2023