Revenue Ruling Clarifies Deductibility of Accrued Payroll Taxes

Revenue Ruling Clarifies Deductibility of Accrued Payroll Taxes

By Kevin F. Powers, CPA

Corporate taxpayers, including many financial institutions, using the accrual method of accounting have faced confusion for years over the proper treatment of accrued payroll taxes. Author Kevin Powers describes how the Internal Revenue Service (IRS) has recently clarified the treatment, to the benefit of such taxpayers.

In the past, the IRS took the position that FICA and FUTA taxes (that is, payroll taxes) for accrual-method taxpayers were treated as incurred only in the taxable year that the taxpayer paid the compensation related to that payroll tax liability. Generally, if a taxpayer accrues both compensation and payroll taxes during Year 1 and satisfies certain requirements, it can deduct the taxes in Year 1. Revenue Procedure 2008-52 (which incorporates changes made by a revenue procedure issued earlier in the year), however, now allows taxpayers to deduct payroll taxes for compensation liability that would not be paid until a later tax period.

The Issue
Internal Revenue Code Section 461(a) provides that the amount of any deduction or credit must be taken for the taxable year that is the proper taxable year under the method of accounting used in computing taxable income. Regulation Section 1.461-1(a)(2)(i) states that under an accrual method of accounting, a liability (including payroll tax liability) is incurred and generally taken into account for federal income tax purposes in the taxable year in which:

1. All the events have occurred that establish the fact of the liability;

2. The amount of the liability can be determined with reasonable accuracy; and

3. Economic performance has occurred with respect to the liability (the “all events test”).

The third criterion would seem to require the taxpayer to actually pay the payroll taxes before claiming the related deduction; however, Regulation Section 1.461-5(b)(1) carves out a recurring item exception to the general rule of economic performance. Under the provision, a liability is treated as incurred during a taxable year if:

1. All events have occurred that establish the fact of the liability and the amount can be determined with reasonable accuracy;

2. Economic performance occurs on or before the earlier of: a) the date the taxpayer files a return for the taxable year; or b) the 15th day of the ninth calendar month after the close of the taxable year;

3. The liability is recurring in nature; and

4. Either the amount of the liability is not material or accrual of the liability in the taxable year results in better matching of the liability against the income to which it relates than would result from accrual of the liability in the taxable year in which economic performance occurs (that is, when the payroll taxes are paid).

A taxpayer that has a fixed liability to pay the compensation to which the payroll taxes relate might not know at the end of the taxable year whether a particular employee will have reached any applicable payroll tax ceiling by the time the tax is ultimately paid. This raises a question about when the payroll tax liability is considered fixed.

The Safe Harbor Method
The revenue procedure provides that under the safe harbor method of accounting, a taxpayer will be treated as satisfying the requirements for the recurring item exception for payroll tax liability in the same taxable year that all events have occurred that establish the liability. This assumes the liability can be determined with reasonable accuracy.

To illustrate, “X Bank” is an accrual-method taxpayer that properly changes to the safe harbor method of accounting for its payroll tax liabilities. At the end of Year 1, the bank approves a bonus pool of $1 million to be paid on Jan. 5 of the following year to its employees for services provided during Year 1. Assume that as of Dec. 31 in Year 1, all events have occurred to establish the bonus liability and the amount of the liability is determinable with reasonable accuracy. Because the taxpayer has elected the safe harbor method, the payroll taxes related to the bonus will be treated as having occurred in Year 1; the amount of the payroll tax liability will be treated as being determined with reasonable accuracy in Year 1. Thus, X Bank can deduct its share of the payroll tax liability in Year 1.

Adapting to the Clarification
Note that a change in the treatment of payroll liabilities to satisfy the safe harbor method constitutes a change in method of accounting. Therefore a taxpayer must file Form 3115, “Application for Change in Accounting Method,” to be able to deduct the payroll liability. The form is filed with the tax return for the year in which a taxpayer changes its method.

Revenue Procedure 2008-52 is effective for taxable years ending on or after Dec. 31, 2007. The IRS will not challenge a taxpayer’s use of the safe harbor method of accounting on a federal income tax return filed before March 11, 2008, if the taxpayer meets the procedure’s requirements in that taxable year.

Kevin Powers is an executive with Crowe Horwath LLP in the Oak Brook, Ill., office. He can be reached at 630.586.5140 or kevin.powers@crowehorwath.com.

Download PDF

Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.