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Payroll Tax Deductions on Accrued Vacation and Bonuses Accelerated

Accrual method taxpayers are now allowed to adopt a safe harbor method for accruing Federal Insurance Contribution Act (FICA) and Federal Unemployment Tax Act (FUTA) taxes related to deferred compensation and vacation pay, according to Rev. Proc. 2008-25 as released by the IRS. This revenue procedure is effective for taxable years ending on or after December 31, 2007.

Understanding the safe harbor

Under the safe harbor, accrual method taxpayers can make an automatic accounting method change request to accrue the employer portion of payroll taxes attributable to accrued compensation and vacation pay. They may simultaneously adopt the recurring item exception to the economic performance requirements for accrued payroll tax liabilities.

Simply put, instead of waiting until next year, businesses in this category are permitted to take these deductions this year. “It’s a potential acceleration of tax deductions, which means you keep cash in your pocket today,” says Bob Ranweiler, tax principal with LarsonAllen.

The safe harbor provision does not apply to the employee’s portion of FICA tax attributable to deferred compensation and accrued vacation pay that is deducted by the employer from wages paid to the employee.

Background

For many years, the IRS didn’t allow accrual method taxpayers to accrue and deduct FICA and FUTA taxes until the year that compensation related to the payroll tax was actually paid. In general, deferred compensation (defined as accrued compensation paid more than two and a half months after year end) is only deductible by an employer in the year that it is paid to the employee.

Benefits of the new safe harbor

The IRS has liberalized the rules on deductions. This new accounting method change, combined with the recurring item exception, allows taxpayers to accrue payroll taxes that will be paid by the earlier of the filing of the tax return, or within eight and a half months after the end of the taxable year. Taxpayers are also allowed to accrue payroll taxes related to deferred compensation that is paid more than two and a half months after the close of the taxable year. This result occurs even though the accrual taxpayer cannot deduct the deferred compensation until paid.

Examples

Following are two examples of how this accounting method change applies:

Example 1: Accrual of payroll taxes on vested vacation pay
Little, Inc., an accrual method, calendar-year corporation, has previously adopted use of the recurring item exception. Little properly now adopts the safe harbor method for its payroll tax liabilities. During 2008, an employee of Little earns $10,000 of vested vacation compensation for services performed during 2008. Little pays the vacation pay in May 2009, incurring a payroll tax liability for the $10,000 of vested vacation pay.

In its 2008 taxable year, Little’s vacation compensation liability and the amount of the liability is determinable with reasonable accuracy. Accordingly, all events necessary to establish Little’s payroll tax liability associated with the $10,000 of vested vacation pay have occurred at the end of 2008, and the payroll tax liability is allowed as an accrued deduction in 2008.

 

Example 2: Deductibility of payroll taxes on large bonus pool
Big, Inc., an accrual method, calendar-year taxpayer, has previously adopted the recurring item exception. Big adopts the safe harbor method of accounting for accrued payroll taxes. On December 28, 2008, Big’s board of directors approves a bonus pool of $1 million to be paid to employees for services provided during 2008. The bonuses are paid to employees on January 5, 2009, and Big incurs a payroll tax liability on these bonuses.

As of the end of the 2008 taxable year, all events have occurred to establish the fact of the bonus liability and the amount of the liability can be determined with reasonable accuracy. For purposes of the recurring item exception, all events necessary have established Big’s payroll tax liability for the $1 million of bonuses. That liability is treated as having occurred in 2008 and is therefore allowed as an accrued deduction in the 2008 taxable year.


Implementation

“Changes in accounting method represent a complex area. Special forms need to be prepared and filed with the IRS, and the IRS will return the form if it’s erroneously prepared,” Ranweiler says.

Taxpayers are required to attach a Form 3115 to its timely filed return for the year of the accounting method change. A copy of the Form 3115 must also be filed with the IRS’ national office.

“Every accrual method taxpayer should have a professional assess the applicability to your business,” Ranweiler says. “We can help you understand the rules, whether you qualify, and if the benefit of the current tax savings justifies the complexity of requesting the change in accounting method.”

For more information, contact us.

Published: 9/19/2008

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