IRS Issues Revenue Ruling on Deductibility of Payroll Taxes Incurred on Deferred Compensation

On February 15, 2007, the Internal Revenue Service (“IRS”) issued Revenue Ruling 2007-12, which addresses the timing of deductibility by accrual method taxpayers of the employer’s portion of FICA and FUTA payroll taxes paid with respect to deferred compensation. Generally, Rev. Rul. 2007-12 permits an accrual method taxpayer to deduct the taxes in the year in which the income is earned and vests (“Year 1”), rather than in the later year in which the deferred compensation may be able to be deducted, provided that the taxes are paid prior to the earlier of the date on which the taxpayer files its return for Year 1 or September 15 of the immediately following year (for calendar year taxpayers). In practice, this ruling may accelerate by one year the deduction for FICA and FUTA taxes - i.e., taxes “accrued” in Year 1 but not paid until the following year can be deducted in Year 1 - and clarifies that the rule under Section 404 of the Internal Revenue Code of 1986 (the “Code”) deferring the timing of the deduction for deferred compensation itself does not affect the timing of the deduction for the payroll taxes. A taxpayer who wishes to change its treatment of payroll taxes associated with deferred compensation based on Rev. Rul. 2007-12 must treat the change as a change to its method of accounting, and obtain the Commissioner’s consent to such change under Section 446(e) of the Code.

Section 404 of the Code governs the timing of an employer’s deduction with respect to deferred compensation. Under Section 404, compensation is treated as deferred if it is paid more than two and one-half months after the end of the employer’s taxable year in which the services are performed. Generally, an employer is entitled to deduct deferred compensation only in the year in which the compensation is includible in the gross income of the employee – i.e., usually, in the year in which the compensation is paid.

Section 461 of the Code provides that the timing of deductions is governed by a taxpayer’s method of accounting. Regulations under Section 461 provide that an accrual method taxpayer incurs a liability in the taxable year in which the “all events test” is met. The all events test requires that (1) all events have occurred that establish the liability, (2) the amount of the liability can be determined with reasonable accuracy and (3) economic performance has occurred. With respect to compensation for personal services, economic performance generally occurs as the services are provided. In the case of a taxpayer’s liability to pay taxes, economic performance generally occurs as the taxes are paid.

However, the recurring item exception provides that a liability may be treated as incurred for a taxable year where (1) at the end of the taxable year, all events have occurred that establish the liability and the amount can be determined with reasonable accuracy, (2) economic performance occurs on or before the earlier of (a) the date that the taxpayer files a return (including extensions) for such taxable year or (b) the 15th day of the 9th calendar month after the close of such taxable year, (3) the liability is recurring in nature and (4) the amount of the liability is not material or the accrual of the liability in such taxable year results in better matching of the liability against the income to which it relates. In the case of a liability for taxes, the matching requirement in (4) is deemed satisfied.

In Revenue Ruling 69-587, 1969-2 C.B. 108, the IRS concluded that an accrual basis taxpayer could not deduct payroll taxes payable with respect to bonuses and vacation pay accrued but unpaid at year-end until the taxable year in which the bonuses and vacation pay are paid. The holding was based on the logic that FICA and FUTA tax liability is not established until the time that bonus and vacation payments are paid. In Revenue Ruling 96-51, the IRS concluded that an accrual basis taxpayer could deduct payroll taxes in respect of wages that are in earned in one year but for which payroll taxes are paid in the following year (presumably, for the pay period that spans the end of the taxable year), in accordance with the all events test and the recurring item exception. Neither Rev. Rul. 69-587 nor Rev. Rul. 96-51 considered Section 404 of the Code.

In Rev. Rul. 2007-12, the IRS held that because an employer’s liability for payroll taxes does not represent compensation paid or accrued on account of an employee, Section 404 does not control the timing of deductibility for such taxes. Moreover, the IRS disregarded the logic underlying, and revoked, Rev. Rule 69-587. Accordingly, the IRS held that the timing of deductibility of the employer’s portion of FICA and FUTA payroll taxes is governed by Section 461 of the Code and not Section 404 of the Code, and that subject to compliance with the all events test and the recurring item exception of Section 461 of the Code, an accrual basis taxpayer may treat its payroll tax liability as incurred in the year in which the payroll tax liability arises, even if the tax is not paid until the following year and the compensation to which the liability relates is deferred compensation not deductible until a future year.