Given a choice
between recognizing income now or in a later year, most people want
to be paid now and be taxed in a later year. As a practical matter,
however, an employee cannot defer compensation after performing
services and becoming entitled to payment. Routine compensation
earned over a prescribed pay period -- a week, two weeks, or a
month, for example - usually is paid or made available in the same
year it was earned. Recognition of the income cannot be put off to a
later year.
If the employee
earns compensation in one year but will not receive it until the
following year, the amount is treated as deferred compensation (unless
the employer has funded or secured its obligation to pay, or the 2
1/2 month rule, noted below, applies). If an amount is treated as
deferred compensation, the employer cannot take a deduction until the
year the employee includes the compensation in income. This rule applies
even if the employer is on the accrual basis and all events have
occurred that entitle the employee to a specific bonus amount. This
"matching" principle is contained in Code Sec. 404(a)(5).
The 2 1/2 Month Rule
However, payments made in the first 2 1/2 months of the end of the year
that the services were performed are not treated as deferred
compensation. This allows the employer to accrue and deduct the
compensation in the year it is earned (the year the services were
performed), not the later year when it is paid. Nevertheless, the
employee still is entitled to defer his or her recognition of income
into the next year if certain conditions are satisfied.
Employers who want
to spare their employees from being taxed in the year a bonus is earned
should not make any amounts available to the employee until the
following year. This is particularly important if the employee earns a
bonus based on an objective measure, such as corporate earnings. If the
bonus is paid solely in the employer's discretion, the amounts will not
be taxable until the year paid. If the bonus is paid within the first 2
1/2 months of the following year, the amount is not deferred
compensation, and an accrual-basis taxpayer can deduct the bonus in the
year the employee performed the services.
Elective Deferral
Requirements
If an employer wants to give the employee an election to defer the
bonus, it is necessary to look to Code Sec. 409A, enacted in the
American Jobs Creation Act of 2004. Under Code Sec. 409A, a bonus
based on measures of the company's or the individual's performance is
treated as deferred compensation. If the bonus is based on services
performed over a 12-month period or longer, the employee must make an
election to defer income at least six months before the end of the bonus
period.
