Guest Article

(From the September 8, 2008 issue of Deloitte's Washington Bulletin, a periodic update of legal and regulatory developments relating to Employee Benefits.)

Revenue Procedure 2008-52 May Provide a New Automatic Change in Accounting Method for Employee Bonuses

Revenue Procedure 2008-52 creates a new automatic accounting method change for employee bonuses, which may allow employers that have been using an impermissible accounting method to switch to a permissible method in some situations. This is effective for change requests filed on or after August 18, 2008 for a year of change ending on or after December 31, 2007. The revenue procedure and Announcement 2008-84 provide some transition rules for requests previously filed and for some not yet filed.

Background

When a taxpayer changes its treatment of the timing of an item's inclusion in income or deductibility a change in accounting method often occurs. An accounting method generally is adopted when an item is treated the same way in determining gross income or deductions in two or more consecutively filed federal income tax returns, even if the method is impermissible, or if a taxpayer treats an item properly in the first return that reflects the item, even if the taxpayer does not treat the item consistently in two or more consecutive returns. Correcting mathematical errors or errors in the computation of tax liability is not considered a change in accounting method.

Once a taxpayer has adopted an accounting method, the taxpayer may not change the method simply by amending its income tax return -- the consent of the Commissioner is generally required. Consent is normally requested by filing a Form 3115, Application for Change in Accounting Method, during the taxable year in which the taxpayer wants to make the change. Unless specifically authorized by the Commissioner, retroactive accounting method changes are not permitted, even if the change is from an impermissible method to a permissible method.

There are two basic types of accounting method change requests: automatic and advance consent (commonly referred to as "manual"). Automatic change requests generally must be filed in duplicate. The original must be attached to the timely filed (including extensions) federal income tax return for the year of change, and a copy must be filed with the national office between the first day of the year of change and the date on which the federal income tax return for the year of change is filed. Manual change requests must be filed during the year for which the change is requested and cannot be taken into account in the taxpayer's federal income tax return until the taxpayer receives a favorable letter ruling from the IRS and signs and returns the consent agreement copy.

If a change in accounting method would cause the item to be included in income or deducted more than once or not at all, IRC § 481(a) generally requires that adjustments be made to prevent that result. For voluntary changes with a net positive IRC § 481(a) adjustment (e.g., when the item would be deducted twice), the adjustment generally is spread over four taxable years. For involuntary changes and voluntary changes with a net negative IRC § 481(a) adjustment (e.g., when a deduction is accelerated as a result of the change) the adjustment generally must be taken into account completely in the year of change. In some cases, however, the change in accounting method is made on a cut-off basis, and only items that arise prospectively are accounted for under the new method. In those cases, no IRC § 481(a) adjustment is necessary.

Revenue Procedure 2008-52

Revenue Procedure 2008-52 provides the exclusive procedure for a taxpayer within its scope to obtain the Commissioner's consent to change its method of accounting. Among the changes of accounting within the scope of Revenue Procedure 2008-52 is a change by an accrual method taxpayer to treat bonuses as incurred in the taxable year in which all events have occurred that establish the fact of the liability to pay a bonus (i.e., the liability is fixed) and the amount of the liability can be determined with reasonable accuracy (i.e., the liability is determinable), but only if (1) the terms of the bonus liability have been made available to employees, (2) the amount of the bonus is calculable as of year-end, and (3) the bonus is received by the employee by the 15th day of the third calendar month after the end of that taxable year (i.e., is not deferred compensation under Treasury Regulation § 1.404(b)-1T, Q&A-2(b)(1) and, therefore, the timing of the deduction is in accordance with the taxpayer's normal method of accounting rather than being governed by IRC § 404(a)(5)). (Additional requirements apply if the taxpayer is required to capitalize these costs, but is not currently doing so.) Rev. Proc. 2008-52, § 19.01(2). If these requirements are satisfied, then the consent of the Commissioner will automatically be granted once the taxpayer files Form 3115.

Common Situations in Which Revenue Procedure 2008-52 Applies

Section 19.01(2) of Revenue Procedure 2008-52 applies in the following three common situations:

Applying for an Automatic Change in Accounting

To apply for an automatic change in accounting method under Revenue Procedure 2008-52 and begin deducting bonuses in the year in which they are paid, an employer would need to file Form 3115 in duplicate. The original must be attached to the employer's timely filed (including extensions) original federal income tax return for the year of change, and a copy must be filed with the national office between the first day of the year of change and the date on which the original is filed with the federal income tax return for the year of change. The Form 3115 must designate the year of the change, which must end on or after December 31, 2007. This will give rise to a net positive section 481(a) adjustment equal to the amount that was mistakenly deducted in the prior year, and that amount will be spread over four taxable years.

For example, if the employer deducted $1 million under its impermissible method of accounting in its 2007 federal income tax return and requested an automatic change in accounting method for 2008 on or after August 18, 2008, under Revenue Procedure 2008-52, then the employer would deduct the $1 million again on its 2008 federal income tax return and $250,000 would be added to the employer's gross income each year from 2008 through 2011. The original Form 3115 would need to be attached to the employer's timely filed 2008 federal income tax return (e.g., September 15, 2009), and the duplicate copy would need to be filed with the national office between the first day of the year of change (e.g., January 1, 2008) and the date on which the original is filed with the federal income tax return for the year of change (e.g., September 15, 2009).

Applying for a Manual Change in Accounting

To apply for a manual change in accounting method, the employer must file Form 3115 during the year for which the change is requested. The change cannot be taken into account in the taxpayer's federal income tax return until the taxpayer receives a favorable letter ruling from the IRS and signs and returns the consent agreement copy. This will give rise to a net positive IRC § 481(a) adjustment equal to the amount that was mistakenly deducted in the prior year, and that amount will be spread over four taxable years beginning with the first year for which the change is taken into account in the taxpayer's federal income tax return.

For example, if the employer deducted $1 million under its impermissible method of accounting in its 2007 federal income tax return and requests a manual change in accounting method in 2008, then the change cannot be taken into account in the taxpayer's 2008 federal income tax return unless the taxpayer receives a favorable letter ruling from the IRS and signs and returns the consent agreement copy by the due date (including extensions) of its federal income tax return (e.g., September 15, 2009). If approval is granted, the employer will deduct the $1 million on its 2008 federal income tax return and $250,000 would be added to the employer's gross income each year from 2008 through 2011.

The Pooled Bonus Alternative

Having changed their method of accounting to a permissible method, some employers will want to redesign their bonus plans to take tax deductions in the year in which the services giving rise to the bonuses were performed rather than taking deductions in the following year when amounts are actually paid. The new bonus plan could be designed to provide a year-end deduction, giving the employer a deduction that would offset the IRC § 481(a) adjustment that arose from its change in accounting method.

Under the pooled bonus approach, the employer commits by year end to pay a particular aggregate bonus amount within 2? months after the end of the year. Although the specific amount of each employee's bonus does not have to be determined until later, the aggregate amount cannot change no matter what happens.

For example, if bonuses are entirely discretionary, then the amount that the employer allocates to each employee could continue to be discretionary, but the employer would have to pay the entire aggregate amount of bonuses it committed to pay to some eligible employee or employees within 2? months after year end; it could not retain any portion of that amount. Likewise, if employees must be employed on the bonus payment date to receive a bonus, then amounts that would have been paid to an employee who quits before the payment date would have to be reallocated to other eligible employees and paid within 2? months after year end.

If an employer commits to pay the maximum amount it expects to pay, then it will be required to give larger bonuses to individual employees than it intended if the employer's financial performance is not as strong as the employer expects or more employees quit than the employer expects. To reduce the likelihood of that result, the employers can commit to a smaller amount than the maximum amount it expects to pay (e.g., 90 percent). If it actually pays more than that amount within 2? months after year end, then the additional amount is simply deducted in the year it is paid.

Covered employees under IRC § 162(m) should be excluded from the reallocation of additional amounts under the guaranteed bonus pool if the employer is relying on the qualified performance-based compensation exception with respect to their bonuses. The discretion to increase a covered employee's bonus disqualifies the amount as qualified performance-based compensation, making the payment subject to the $1 million deduction limitation under IRC § 162(m). Given the size of the bonuses for IRC § 162(m) covered employees, some employers set up a separate pool for these employees and accrue a smaller percentage (e.g., 75 percent) or choose not to accrue bonuses for these employees in the prior year, instead deducting these amounts in the year in which they are actually paid.

The information in this Washington Bulletin is general in nature only and not intended to provide advice or guidance for specific situations. If you have any questions or need additional information about articles appearing in this or previous versions of Washington Bulletin, please contact: Robert Davis 202.879.3094, Elizabeth Drigotas 202.879.4985, Mary Jones 202.378.5067, Stephen LaGarde 202.879-5608, Erinn Madden 202.572.7677, Bart Massey 202.220.2104, Mark Neilio 202.378.5046, Tom Pevarnik 202.879.5314, Sandra Rolitsky 202.220.2025, Tom Veal 312.946.2595, Deborah Walker 202.879.4955. Copyright 2008, Deloitte.