Deducting Payroll Taxes on Deferred Compensation
The IRS recently determined that Sec. 461, rather than Sec. 404, governs the timing of the deduction for payroll taxes on deferred compensation by an accrual-basis taxpayer.
Generally under Sec. 461(a), a deduction is taken into account in the proper tax year under the taxpayer’s accounting method. Regs. Sec. 1.461-1(a)(2) allows an accrual-method taxpayer to take expenses into account (as a deduction or capital item) in the tax year in which all the events have occurred that determine the fact of the liability and the amount can be determined with reasonable accuracy (the all-events test).
The all-events test is met no earlier than when economic performance occurs; see Sec. 461(h)(1). For liabilities arising out of the performance of services for a taxpayer, economic performance occurs as such services are performed; however, Regs. Sec. 1.461-4(d)(2)(iii) provides that the economic-performance requirement is satisfied for employee compensation if an amount is otherwise deductible under Sec. 404.
Under Sec. 404(a), compensation paid to an employee under a plan deferring the receipt of such payments is not deductible until paid. However, Temp. Regs. Sec. 1.404(b)-1T, Q&A-2, provides that salary under an employment contract and a bonus under a year-end bonus declaration are not considered paid under a plan, method or arrangement deferring the receipt of compensation to the extent that such salary or bonus is received by the employee on or before the end of the applicable 2½-month period beyond the taxpayer’s year-end; see Avon Products, Inc., 97 F3d 1435 (Fed. Cir. 1996). Thus, if an amount is paid more than 2½ months after the end of the employer’s tax year, it generally is presumed to be deferred compensation and, thus, subject to Sec. 404.
Before the enactment of the economic-performance rules under Sec. 461(h), the IRS had issued Rev. Rul. 69-587, which concluded that, under the all-events test, an accrual-method employer generally cannot deduct payroll taxes payable with respect to vested bonuses and vacation pay accrued but unpaid at year-end until the tax year in which the bonuses and vacation pay are paid.
In Eastman Kodak Co., 534 F2d 252 (Ct. Cl. 1976), the court held that, under the all-events test, the fact of the employer’s liability for the taxes was established as an automatic consequence of its definite and legal obligation to pay the underlying year-end accrued wages, even though no legally enforceable obligation to pay the taxes in issue had arisen by year-end. In Rev. Rul. 96-51, the Service announced its acquiescence in Eastman Kodak. The silence in both Rev. Ruls. 69-587 and 96-51 as to the applicability of Sec. 404 and the divergent conclusions reached by the IRS in the rulings caused confusion for some taxpayers and tax practitioners. In releasing Rev. Rul. 2007-12, the Service amplified Rev. Rul. 96-51 and revoked Rev. Rul. 69-587.
Rev. Rul. 2007-12
In the ruling:
Applicability of Sec. 404
In Rev. Rul. 2007-12, the IRS explained that Sec. 404 applies to compensation paid or accrued by an employer on account of any employee under a deferred-compensation plan. An employer’s liability for payroll taxes does not represent compensation paid or accrued by an employer; thus, Sec. 404 does not control the deductibility of an employer’s liability for payroll taxes — even if said liability relates to a deferred-compensation liability subject to the Sec. 404 deduction rules. Accordingly, the Service concluded that Sec. 404 does not alter the timing of the accrual under Sec. 461 of a taxpayer’s payroll tax liability for compensation. In issuing this ruling, the IRS clarified its position on the applicability of Sec. 404 and resolved the apparent conflict between Rev. Ruls. 69-587 and 96-51.
The conclusion in Rev. Rul. 2007-12 — that Sec. 404 does not alter the timing of the accrual of the taxpayer’s payroll tax liability under Sec. 461 — is significant; previously, the IRS had been allowing method changes involving this issue for payroll taxes only on compensation paid within two and one-half months (rather than 8½ months, as allowed under the recurring-item exception) of a taxpayer’s year-end. This limit was apparently imposed because there was confusion, not so much as to the applicability of Sec. 404, but because Sec. 3121 seems to distinguish between a payroll tax liability with respect to deferred compensation (i.e., compensation paid beyond 2½ months of a taxpayer’s year-end) and nondeferred compensation (i.e., compensation paid within 2½ months of a taxpayer’s year-end).
Effect of Rev. Rul. 2007-12
Rev. Rul. 2007-12 Rev. Rul. 2007-12 did not definitively indicate when the liability for such payroll taxes is fixed under a particular fact pattern. IRS and Treasury officials acknowledge that they have deferred answering the difficult question about the timing of the liability for payroll taxes on deferred compensation in this ruling. They have also indicated, however, that they expect that, in some cases, taxpayers will be able to meet the fixed requirement of the all-events test of Sec. 461; thus, some taxpayers may be able to accrue certain payroll taxes on deferred compensation paid to employees up to 8½ months beyond the end of the taxpayer’s year-end under the recurring-item exception of Regs. Sec. 1.451-5.
Generally under Regs. Sec. 1.461-4(g)(6), if a taxpayer is liable to pay a tax, economic performance occurs as the tax is paid to the government authority that imposed it. Regs. Sec. 1.451-5 provides an exception to the rules of economic performance; it generally allows a deduction for a liability in the year the all-events test is met, regardless of whether economic performance has occurred. Further, under Regs. Sec. 1.461-5(b)(5)(ii), the liability for taxes automatically satisfies the matching requirement of the recurring-item exception.
In any event, Sec. 461(h)(1) provides that “the all events test shall not be treated as being met any earlier than when economic performance with respect to such item occurs.” Thus, taxpayers must examine the facts and circumstances of each particular type of payroll tax on deferred compensation to determine whether the underlying payroll tax liability is fixed under the all-events test. Exhibits 1 and 2 indicate how Social Security or Old Age, Survivors and Disability Insurance (OASDI) portion of the FICA tax applies only to wages of $97,500 or less for calendar-year 2007. As such, when an employee’s bonus or vacation is vested at the end of one year but not paid until the following year after the employee’s wages exceed the FICA wage limit, the tax will not be paid. Accordingly, a question exists as to whether the payroll tax liability is fixed in the earlier year. Further, because taxes are a payment liability under the recurring-item exception, if payment is never made, such amount is not accruable. (See also Rev. Rul. 2007-3, which provides guidance on when a liability for services or insurance is fixed under Sec. 461 for a taxpayer using an accrual method of accounting.) Nevertheless, Rev. Rul. 2007-12 is a very positive step forward.
Change in Accounting Method
The Service noted that a taxpayer’s change in its treatment of payroll tax liabilities associated with deferred compensation to comply with Rev. Rul. 2007-12 is an accounting-method change within the meaning of Secs. 446 and 481. Thus, a taxpayer seeking to change its treatment of payroll taxes associated with deferred compensation to comply with Rev. Rul. 2007-12 must obtain advance IRS consent under Rev. Proc. 97-27.
It is not entirely clear why the Service did not issue a companion procedure that would permit a taxpayer to automatically change, under Rev. Proc. 2002-9, its treatment of payroll tax liabilities associated with deferred compensation to comply with Rev. Rul. 2007-12. Presumably, this was because the IRS failed to provide any guidance on the more fundamental issue of whether the liability for payroll taxes is fixed under the all-events test and, thus, wants to review each taxpayer’s specific facts and circumstances.
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Paul K. Gibbs, CPA, Washington, DC, is a contributing writer for The Tax Adviser. His views as expressed in this article do not necessarily reflect the views of the AICPA or The Tax Adviser.