Abstract:   An annual bonus plan can help attract, retain and motivate employees. And if the plan is designed carefully, the taxpayer can deduct bonuses earned this year even if he or she doesn’t pay them until next year. This article explains certain rules, such as the 2½ month rule and the all-events test.

Designing a tax-wise bonus plan

An annual bonus plan can be a great way to attract, retain and motivate employees. And if the plan is designed carefully, you can deduct bonuses earned this year even if you don’t pay them until next year.

The 2½ month rule

Many employers are aware of the “2½ month rule” and assume they can deduct bonuses earned during a tax year so long as they pay them within 2½ months after the end of that year (by March 15 for a calendar-year company). But that’s not always the case.

For one thing, this tax treatment is available only to accrual-basis taxpayers — cash-basis taxpayers must deduct bonuses in the year they’re paid, regardless of when they’re earned. Even for accrual-basis taxpayers, however, this treatment isn’t automatic. Bonuses can be deducted in the year they’re earned only if the employer’s bonus liability is fixed by the end of the year.

The all-events test

For accrual-basis taxpayers, the IRS determines when a liability (such as a bonus) has been incurred — and, therefore, is deductible — by applying the “all-events test.” Under this test, a liability is deductible when:

1. All events have occurred that establish the taxpayer’s liability,
2. The amount of the liability can be determined with reasonable accuracy, and
3. Economic performance has occurred.

Generally, the third requirement isn’t an issue; it’s satisfied when an employee performs the services required to earn a bonus. But the first two requirements can delay your tax deduction until the year of payment, depending on how your bonus plan is designed.

For example, many bonus plans require an employee to remain in the company’s employ on the payment date as a condition of receiving the bonus. Even if the amount of the bonus is fixed at the end of the tax year, and employees who leave the company before the payment date forfeit their bonuses, the all-events test isn’t satisfied until the payment date. As discussed below, however, it’s possible to accelerate deductions with a carefully designed bonus pool arrangement.

Everyone into the pool

One solution to the problem described above is to establish a bonus pool. In a 2011 ruling, the IRS said that employers may deduct bonuses in the year they’re earned — even if there’s a risk of forfeiture — so long as any forfeited bonuses are reallocated among the remaining employees in the pool rather than retained by the employer.

Under such a plan, an employer satisfies the all-events test because the aggregate bonus amount is fixed at the end of the year, even though amounts allocated to specific employees aren’t determined until the payment date.

In reaching this result, the IRS has emphasized that the employer must:

1. Define the terms and conditions under which bonuses are paid,
2. Pay bonuses for services performed during the tax year,
3. Communicate the plan’s general terms to employees when they become eligible and when the plan is changed,
4. Determine the minimum aggregate bonus amount either through a formula fixed before year end, or based on a board resolution or other corporate action taken before year end, and
5. Reallocate forfeited bonuses among other eligible employees.

Item 4 above is significant: It indicates that a bonus plan satisfies the all-events test if the minimum aggregate bonus is determined according to a formula that’s fixed by year end. This allows employers to deduct performance-based bonuses tied to earnings or other financial benchmarks, even if the exact amount isn’t determined until after year end, when the company’s financial reports are prepared.

To ensure that bonuses are deductible this year, employers shouldn’t retain any discretion to modify or cancel bonuses before the payment date or condition bonuses on approval by the board or a compensation committee after the end of the year.

Plan carefully

Designing a bonus plan that allows you to accelerate deductions into this year for bonuses paid next year can reduce your tax bill and boost your cash flow. To enjoy these benefits, work with us to ensure you satisfy the all-events test.

Download the 2017 – 2018 Tax Planning Guide

Federal tax law allows deductions for many items, such as legitimate business expenses and charitable donations. But, if you claim deductions on your tax return, you also must maintain adequate records to support them. If your tax return is audited, missing or incomplete records could lead to additional taxes, interest and penalties, as these three recent U.S. Tax Court cases demonstrate.

How Long Should You Retain Tax Records?

In general, any written evidence that supports figures on your tax return, such as receipts, expense logs, bank notices and sales records, should generally be kept for at least a three-year period. That’s because the statute of limitations generally runs out three years from the due date of the return for the year in question or the date you filed, whichever is later. So in most cases the IRS can decide to audit your return anytime within that three-year window.

You can also file an amended return on Form 1040X during this time period if you missed a deduction, overlooked a credit or misreported income.

Important note: There are some cases when taxpayers get more than the usual three years to file an amended return. You have up to seven years to take deductions for bad debts or worthless securities, so don’t toss out records that could result in refund claims for those items.

So, does that mean you’re safe from an audit after three years? Not necessarily. There are some exceptions. For example, some records support figures affecting multiple years, such as carryovers of charitable deductions, net operating loss carrybacks or carryforwards, or casualty losses. The IRS recommends that you save these records until the deductions no longer have effect, plus seven years.

Alternately, if the IRS has reason to believe your income was understated by 25% or more, the statute of limitations for an audit increases to six years. Or, if there’s suspicion of fraud or you don’t file a tax return at all, there is no time limit for the IRS to launch an inquiry.

In addition, you should keep records related to real estate for as long as you own the property, plus three years after you dispose of it and report the transaction on your tax return. Throughout ownership, keep records of the purchase, as well as receipts for home improvements, relevant insurance claims and documents relating to refinancing. These help prove your adjusted basis in the home, which is needed to figure the taxable gain at the time of sale, or to support calculations for rental property or home office deductions.

Likewise, keep the records for securities for as long as you own the investments, plus the statute of limitations on the relevant tax returns. To accurately report taxable events involving stocks and bonds, maintain detailed records of purchases and sales. These records should include dates, quantities, prices, reinvestment of dividends, and investment expenses, such as broker fees.

If you have questions regarding record retention, contact your tax advisor.

1. Alan Brookes, et ux. v. Commissioner(TC Memo 2017-146)

In this decision, the taxpayers were a married couple who filed a joint tax return. They operated the husband’s financial services and consulting business, along with the wife’s art business, through an S corporation. The S corporation’s losses were passed through to the couple’s personal tax return.

The IRS audited the couple’s tax returns for the 2010 through 2012 tax years, and disallowed many of the business’s deductions, increasing the taxpayers’ taxable income for the three years in question. For example, deductions the taxpayers claimed for travel, meals, entertainment and auto expenses were disallowed because the taxpayers had failed to:

• Keep contemporaneous records,
• Categorize the expenses, and
• Separate business expenses from personal expenses.

However, the IRS allowed partial deductions for advertising, rent, gallery fees and supplies related to the wife’s art business, because the taxpayers had kept receipts from one of the tax years that showed purchase dates and amounts paid. Other deductions were allowed based on the wife’s oral testimony in conjunction with some sketchy recordkeeping.

The IRS also allowed partial deductions for amounts paid for massage therapy to treat the wife’s severe scoliosis, because the S corporation operated a medical expense reimbursement plan. However, deductions the taxpayers claimed for other  medical expenses were disallowed due to inadequate recordkeeping.

The Tax Court concluded that the IRS had acted properly when it disallowed many deductions and also agreed that the taxpayers owed the 20% penalty for negligence on the additional tax assessed. The court opined that the taxpayers had failed to produce adequate records to support the disallowed expenses or demonstrate reasonable cause or good faith in claiming the disallowed expenses. Ultimately, the Tax Court sided with the IRS, charging the taxpayers with additional  federal income tax of roughly $122,000 and a 20% negligence penalty of more than $24,000.

2. Stephen Drah v. Commissioner(TC Memo 2017-149)

In another recent Tax Court case, the taxpayer worked as an independent contractor for FedEx. Specifically, the taxpayer’s wholly owned C corporation contracted to provide services to FedEx and then paid wages to the taxpayer. On his individual return, the taxpayer claimed deductions for contract labor expenses, as well as vehicle depreciation, repair and maintenance.

The IRS audited the taxpayer’s tax return for the 2011 tax year and determined that the taxpayer had generally failed to substantiate the amount and business purpose of many expense deductions. Other business expense deductions — including those related to a vehicle leased by the corporation — were properly deductible by the corporation (and presumably were) but not by the taxpayer on his personal return.

The Tax Court concluded that the taxpayer owed additional income tax of roughly $12,000, plus nearly $4,000 in penalties for failure to file his personal return on time, failure to pay personal federal income tax and failure to make estimated tax payments.

3. Mark R. Ohde v. Commissioner(TC Memo 2017-137)

Another recent Tax Court decision involved married taxpayers who claimed charitable contribution deductions totaling more than $146,000 on their joint 2011 federal income tax return for donations of clothing, media, furniture and other household items. The taxpayers claimed to have donated more than 20,000 items to Goodwill.

The IRS audited the couple’s tax return and disallowed $145,000 of the claimed charitable contribution deductions. Why? The taxpayers had failed to properly substantiate noncash contributions that were purportedly worth more than $250. The receipts supplied by Goodwill didn’t describe the specific items contributed or indicate the number of items of any particular type. Instead, they simply stated that the thousands of items delivered fell into the categories of clothing, shoes, media, furniture and household items. In addition, donations that were purportedly worth more than $5,000 weren’t supported by qualified appraisals.

The Tax Court concluded that the IRS had acted properly in disallowing $145,000 of charitable deductions and assessing the 20% negligence penalty (based on the taxpayers’ inadequate recordkeeping). The Tax Court noted, “The term ‘negligence’ includes any failure to make a reasonable attempt to comply with the tax laws, and ‘disregard’ includes any careless, reckless, or intentional disregard” of the tax laws. The court concluded that recordkeeping failures can amount to negligence.

Bad Records, Bad Outcome

These cases show that inadequate support for tax deductions — such as lack of receipts and other documentation, the use of confusing and inconsistent accounting techniques, and vague testimony — can have expensive tax consequences. In addition to owing additional tax, taxpayers who claim unsubstantiated deductions may also be assessed interest and penalties on their unpaid taxes.

The Internal Revenue Code, the IRS, and the courts don’t distinguish between completely bogus deductions and deductions for legitimate, but unsupported, expenses. In either case, you can get into the same amount of trouble. Will your recordkeeping practices survive IRS scrutiny? Contact your tax advisor to fortify your recordkeeping procedures and help support your valuable tax write-offs.

In a recent blog, National Taxpayer Advocate Nina Olson explained why taxpayers can’t rely on answers to Frequently Asked Questions (FAQs) and Answers and other forms of “unofficial” guidance that are posted on the IRS website. While tax professionals already knew this, many taxpayers may find it to be a disturbing revelation.

Olson’s blog notes that there are three types of tax guidance:

IRS Regulations

Guidance in IRS final and temporary regulations is binding on both the IRS and taxpayers, except in relatively rare instances where a taxpayer is able to persuade a court to invalidate the regulation. Some proposed regulations are also binding on the IRS and taxpayers.

Regulations are subject to careful internal review and public comment before they are issued. If taxpayers rely on guidance published in temporary and final regulations (and some proposed regulations), they can’t be assessed additional taxes or penalties for failing to follow the rules.

Other Official IRS Guidance

In Internal Revenue Bulletins (IRBs), the IRS issues the following forms of so-called published guidance:

• Revenue Rulings,
• Revenue Procedures,
• Notices, and
• Announcements.

The IRS is generally required to follow its own published guidance. However, taxpayers can challenge IRS positions in court and seek to persuade the court that their own interpretation of the underlying tax law is correct. Occasionally, some published guidance is withdrawn or replaced by more current guidance. If taxpayers rely on currently applicable published guidance, they can’t be assessed additional taxes or penalties for failing to follow the rules.

Unofficial Guidance

The IRS puts out what it calls unofficial guidance in many forms including tax forms and instructions, press releases, online publications, website articles and website FAQs and Answers. Such unofficial guidance generally isn’t subject to careful internal review or public commentary before being released. Moreover, the IRS takes the position that taxpayers cannot rely on unofficial guidance even though the IRS has put it out there for public consumption.

For example, FAQs and Answers can be changed at any time and without any public notice. The same holds true for information in IRS publications that are posted on its website. So, if you rely on unofficial IRS guidance in taking a position on a federal tax return, the IRS can audit you and assess additional taxes, as well as interest and penalties on any unpaid taxes, because you didn’t follow the rules — even though what you did was consistent with what the IRS said in unofficial guidance at the time.

Taxpayer Advocate Recommends Changes to IRS Stance

Olson’s blog concludes that it’s unfair to taxpayers that the IRS can change its mind and assess additional taxes, interest and penalties after you’ve filed a tax return based on unofficial IRS guidance. She notes that some unofficial guidance — such as FAQs and Answers — may be published out of necessity in emergency circumstances and when guidance must be issued quickly.

For example, the IRS issued FAQs and Answers to provide quick guidance on the tax treatment for 1) relief provided to victims of Hurricane Katrina, and 2) losses suffered by victims of the Bernard Madoff Ponzi scheme.

Olson recommends that the IRS release FAQs and Answers as official guidance that taxpayers can rely on (similar to IRS Notices and Announcements) as quickly as possible when an issue affects a significant number of taxpayers or will have ongoing relevance.

In addition, Olson recommends that all unofficial guidance include a prominently displayed disclaimer warning taxpayers that the guidance is not binding on the IRS and that taxpayers shouldn’t rely on it because it may not represent the IRS’s official position.

Taxpayers Who Rely on Professional Tax Advice Can Avoid Penalties

Want to avoid IRS penalties? If you hire a competent tax professional and follow his or her advice, you’ll be protected from most IRS penalty assessments as long as you provide the professional with full information about the tax issue in question. Relying on a tax expert demonstrates that you acted in good faith when filing your tax return and reasonably attempted to comply with the tax law. That’s one more good reason to seek professional assistance rather than turning taxes into a risky do-it-yourself project.

Back-to-school season is a good time to review the federal tax breaks that are currently available if you or a loved one will be attending college or graduate school this fall. After all, a higher education degree is one of the biggest investments you’ll ever make.

Applying for Financial Aid

More than 70% of full-time students received grant aid to help pay for higher education costs during the 2016-2017 school year, according to the College Board. Financial aid can substantially reduce college costs, if you apply and qualify. The first step in getting financial assistance is to fill out the Free Application for Federal Student Aid (FAFSA).

The federal college aid formula requires 35% of the assets in your child’s name to be used for college costs. But it only expects about 5.6% of the money in the parent’s name to be spent. So, you may be better off keeping accounts in a parent’s name, especially during the last two years of high school, which is generally when you’ll be asked to start providing tax returns.

One of the biggest mistakes on the FAFSA involves retirement income and home equity. If you’ve included either of these as an asset on the FAFSA or any supplemental financial aid forms, you’ve made a big mistake. For the  purposes of financial aid, your home equity and retirement savings generally aren’t considered when aid is calculated.

Important note: Depending on the school, a different methodology or combination of formulas may be used to calculate financial aid awards. Parents must fill out the FAFSA and then fill out another form that asks for additional information.

Many private colleges and universities use the Institutional Methodology, which penalizes families with a great deal of home equity but permits more generous treatment of items such as medical expenses, elementary and secondary school tuition and child support. It also assumes the student will spend some time each year working to earn money.

A third methodology, called the Consensus Approach, is now used by approximately 30 colleges and universities, including Yale, Cornell, Stanford, MIT, Columbia, Wellesley and Duke. Among its principles: Students’ assets and parents’ assets are treated the same to discourage families from moving assets between generations.

To make matters more confusing, even if a college uses one of the formulas described above, it can still be flexible when awarding its own money. In other words, when awarding federal grants, loans and most state aid, the federal formula is used, but when awarding a school’s own money, each school a student applies to may make calculations differently.

Need help applying for scholarships, loans and other types of financial aid? Your tax advisors can help you fill out forms and compare your options.

Cost Overview

How much does an advanced degree typically cost? For the 2016-2017 school year, the College Board estimates that the average annual cost (including tuition, fees, and room and board) was $20,090 for in-state students at a public four-year school — and $45,370 for students at a private not-for-profit four-year institution. These estimates don’t include books, supplies, transportation and other expenses a student may incur.

In addition to applying for financial aid (see right), you may be eligible for the following tax breaks to help foot the bill. The eligibility requirements vary for each one, and many are gradually phased out if income is above a certain amount.

American Opportunity Credit

This tax break is well known, probably because it provides the biggest benefit to  most taxpayers. Formerly called the Hope credit (which offered more limited benefits), the American Opportunity credit provides a maximum benefit of $2,500. That is, you may qualify for a credit equal to 100% of the first $2,000 of expenses for the year and 25% of the next $2,000 of expenses. It applies only to the first four years of post-secondary education and it’s available only to students who attend at least half time.

Basically, tuition, course materials and fees qualify for this credit. Courses involving sports, games or hobbies generally don’t count. The credit is per eligible student and is subject to phaseouts based on modified adjusted gross income (MAGI).

Lifetime Learning Credit

If you don’t qualify for the American Opportunity credit because the student in question is beyond the first four years of postsecondary education or attends less than half-time, the Lifetime Learning credit is generally the next best option. It equals 20% of qualified education expenses for up to $2,000 per tax return. There are fewer restrictions to qualify for this credit than for the American Opportunity credit.

The Lifetime Learning credit can be applied to education beyond the first four  years, and qualifying students may attend school less than one-half time. The student doesn’t even need to be part of a degree program. So, the Lifetime Learning credit works well for graduate studies and part-time students who take a qualifying course at a local college to improve job skills. This credit applies to tuition, fees and materials. It’s also subject to phaseouts based on MAGI, however.

Above-the-Line Tuition and Fees Deduction

Typically, an education credit will provide greater tax savings than a deduction, because it reduces taxes dollar for dollar. A deduction reduces only the amount of income that’s subject to tax. But the eligibility requirements vary.

In certain, limited situations, an above-the-line deduction for qualified tuition and fees is more beneficial than the American Opportunity or Lifetime Learning credit. Above-the-line means that this deduction is taken to arrive at adjusted gross income (AGI), not taken from AGI. So, an above-the-line tuition and fees deduction could help reduce your income enough to keep you from having other tax breaks phased out due to income-based limits.

Currently, this deduction has been revived only through 2016, but it could possibly be extended by Congress this fall or retroactively next year. In 2016, the maximum deduction was either $2,000 or $4,000, depending on your MAGI — or, if your MAGI exceeded the limit for the $2,000 deduction ($80,000 for single filers and $160,000 for joint filers in 2016), you were ineligible for this tax break. Tuition and fees required for enrollment in or attendance at an eligible postsecondary educational institution generally qualify for this deduction.

Important note: The deadline for individual extended returns is October 16, 2017. If you qualify and you haven’t filed your 2016 income tax return yet, you can take advantage of these breaks on that tax return.

Deduction for Student Loan Interest

Got student loans? You also may be eligible to deduct up to $2,500 per year of interest paid on a qualified student loan. The loan can’t be from a related party and must have been disbursed within 90 days before the start (or within 90 days after the end) of an academic period. In addition, the loan must have been incurred to cover qualified expenses, including tuition, books and fees. It also may cover transportation and room and board, with certain restrictions.

While not as beneficial as a credit, this deduction may be available as long as you’re still paying interest on a loan. Like the other higher education tax breaks, however, it’s subject to a phaseout based on MAGI.

Employer-Provided Educational Assistance

Each year, you can exclude from your income up to $5,250 of educational assistance provided by your employer. Qualifying expenditures include tuition, fees, books, supplies and equipment. Courses can include any academic studies, except for courses involving sports, games or hobbies. The courses don’t necessarily have to be job-related or part of a degree program. Any amount received over the $5,250 limit is taxable income.

In order for the expenses to qualify, the employer must have a written plan for providing educational assistance. Also be aware that IRS rules are designed to prevent discrimination and favorable treatment for owners and related parties.

Business-Related Education Expenses

There’s no dollar limit to the deduction for business-related education expenses, but you must follow certain rules, depending on who’s footing the bill. If an employer pays for job-related classes to maintain or improve an employee’s skills, they’re deductible by the employer. But they’re not income to the employee. Instead, they’re considered a “working condition” fringe benefit.

However, no deduction is allowed for courses that qualify an individual for a new trade or business. Education to maintain or improve skills needed in your present work isn’t qualifying education if it also qualifies you for a new trade or business. The definition of trade or business has been narrowly interpreted by the IRS and courts.

If you pay for courses to improve or maintain your skills (not to qualify you for a new trade or business) and your employer doesn’t reimburse these costs, you may be able to deduct them on Schedule A of your tax return as a miscellaneous itemized deduction. But the deduction is subject to the 2% of AGI threshold — only eligible miscellaneous expenses in excess of 2% of your AGI are deductible.

Other Education-Related Breaks

There are a number of education-related tax breaks that can help fund higher education expenses, such as:

Coverdell Education Savings Accounts (ESAs).

The annual contribution limit for these accounts is $2,000 per beneficiary. Contributions aren’t deductible, but amounts in the account grow tax-deferred. Plus, there’s no tax on distributions used for qualified education expenses. Again, there’s a phaseout based on MAGI.

Section 529 plans.

The concept is similar to Coverdell ESAs — contributions to a 529 savings plan aren’t deductible but grow tax-deferred, and distributions for qualified education expenses are tax-free. But 529 plans are more popular because they have no federally mandated contribution limits. These plans are state-sponsored, and the rules vary by state. For example, some require residency, but many don’t. Some provide a deduction or credit for contributions made by residents. Most follow the federal rules on withdrawals. Ask your tax advisor for the rules in your state. Sec. 529 prepaid tuition plans are also worth exploring with your tax advisor.

Savings bond interest.

You may be able to cash in qualified U.S. savings bonds and exclude some (or all) of the interest on the bonds if the funds are used for educational purposes. To qualify, you must pay qualified education expenses for yourself, your spouse or a dependent for whom you claim an exemption on your tax return. This benefit is also phased out based on MAGI.

IRA penalty exception.

Generally, you can’t take a distribution from a traditional or Roth IRA before age 59-1/2 without incurring a 10% penalty. One exception applies to distributions used for qualified education expenses. Although you won’t incur a penalty, you’ll still have to pay income tax on distributions from traditional IRAs. However, earnings on qualified distributions from Roth IRAs are income-tax-free.

Maximize Your Benefits

Understanding the ins and outs of higher education tax breaks is complicated. The phaseout rules only add to the complexity, because they apply at different levels, depending on the tax break. Multiple factors should be reviewed with a tax advisor before determining which higher education tax breaks to claim.

The IRS is warning about possible fake charity scams that are emerging due to Hurricane Harvey. Taxpayers who want to help should seek out recognized charitable groups to make donations.

“While there has been an enormous wave of support across the country for the victims of Hurricane Harvey, people should be aware of criminals who look to take advantage of this generosity by impersonating charities to get money or private information from well-meaning taxpayers,” the IRS stated. Such fraudulent schemes may involve in-person solicitations or contact by telephone, social media and e-mail.

Criminals often send “phishing” e-mail messages that steer recipients to bogus websites that appear to be affiliated with legitimate charitable causes. These sites frequently try to imitate the websites of — or use names similar to — genuine charities. They sometimes claim to be affiliated with legitimate charities in order to persuade people to send money or provide personal financial information that can be used to steal identities or financial resources.

Follow these Four Tips

People wishing to make disaster-related charitable donations while helping to avoid scam artists should follow these tips:

1. Donate to recognized charities.

But be wary of charities attempting to contact you with familiar names. Some phony charities use names or websites that sound or look like those of respected, legitimate, nationally known organizations. The IRS website has a search feature, Exempt Organizations Select Check. With it, people can find qualified charities and donations to these charities may be tax-deductible (depending on your tax filing status and other factors).

2. Don’t give out personal financial information

such as Social Security numbers or credit card and bank account numbers and passwords — to anyone who solicits a contribution. Scam artists may use this information to steal your identity and money.

3. Never give or send cash.

For security and tax record purposes, contribute by check or credit card or another way that provides documentation of the donation.

4. Report suspected fraud.

Taxpayers suspecting tax or charity-related fraud should visit IRS.gov and perform a search using the keywords “Report Phishing.”

Want More Information?

Additional information about donations can be found in IRS Publication 526, Charitable Contributions, available on IRS.gov. This free booklet describes the tax rules that apply to making legitimate tax-deductible donations. It also provides complete details on what records to keep.

If you want more information about tax scams and scheme, it can be found at IRS.gov using the keywords “scams and schemes.” Details on available relief can be found on the disaster relief page.

And you can always contact us with questions about the tax implications of charitable contributions.