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You may recall from the early 1980's a "2½ month rule" (IRC section 267) under which corporate salary (and other) payments to certain controlling shareholders had to be paid within that 2½ month period after the close of an accrual basis corporation's year. Failure to do so resulted in complete loss of the deduction - not merely deferral until the year paid. When the shareholders were not "controlling" (after applying certain attribution rules), the rule did not apply. Thus, 50/50 shareholders appeared to have flexibility in deferring actual salary payment further into the future.
This rule applicable to controlling shareholders was subsequently modified to require payment in the same year - a payment even one day after the close of the accrual year precluded a current deduction. However, the deduction became merely deferred, not lost. (Note that IRC §267(e) applies this rule if ANY interest is owned in an S corporation and with respect to non "guaranteed payments" to any partners.)
Lurking in the background throughout those years was IRC section 404 - generally pertaining to employee benefit plans. In 1984, section 404 was amended by Congress, and the Treasury Department issued temporary regulations which are still in effect to this day which affect salary payments to non-controlling shareholders as well as to any and all other service providers - establishing a "new" 2½ month rule.
Section 1.404(b)-1T, Q & A-2(b), Temporary Income Tax Regulations, provides for a "bright line" presumption that payments to service providers made more than 2½ months after the close of an accrual basis taxpayer's year are part of a plan or method to defer compensation. This results in the payment being not deductible until includible in the income of the service provider, and the disallowance applies without regard to other relationships between the parties. For example, the disallowance will apply to salaries accrued to certain non-controlling shareholders of C corporations, other employees and independent contractors. The temporary regulations provide taxpayers with the ability to overcome the presumption if the taxpayer can prove that certain circumstances prevented timely payment, but even then such circumstances will not suffice if they were "foreseeable" at the close of the taxpayer's year.
In Truck and Equipment Corp. of Harrisonburg, 98 TC 141 (1992), the court concluded that the "2½ month" temporary regulation was valid, and applied the regulations to a specific set of facts, which are well worth separate careful review. However, in upholding the Service's position, the observations made by the court are most informative. "(The taxpayer) interprets the actions of Congress ... as a refusal to establish a bright-line timing rule. ... The purpose of this temporary regulation is to implement Congress's continuing efforts to address timing distortions that inherently arise between current deductions taken for delayed compensation payments made by accrual method employers and the delayed inclusions of these payments in income by cash method employees. ...(The taxpayer) argues that Congress intended to create a safe harbor for employers who made payments within the 2½ month period but not to create an adverse presumption concerning payments made beyond that period.
"THE TIMING OF PAYMENTS REMAINS THE PRIMARY FOCUS (emphasis added). ...The (regulations have) not inappropriately added conditions to or gone beyond the statute. ...(The taxpayer) characterizes the additional requirement of unforeseeability ... as `an impermissible attempt ... to legislate rather than apply the law enacted by Congress'. ... The requirement for showing the unforeseeability of the economic impracticability that delayed payments is in keeping with Congress's focus on timing distortions. The employer's being able to foresee monetary or administrative problems and thus to control the taking of current deductions and the delaying of receipt of compensation payments is exactly the type of timing distortion Congress was addressing and seeking to restrict."
Further "... Congress and the Secretary are not seeking to permanently disallow a deduction for deferred bonus payments, but merely to match the deduction in the same taxable year as the corresponding inclusion of the
payments into income by the employees. ...T)he unforeseeability requirement is congressionally mandated and appropriately interpreted ... in (the) temporary regulation. ...I)t is the development of such deferral methods ... that Congress ... addressed through section 404 ... rather than [through] the general deduction timing rules ... of the Internal Revenue Code."
In Don E. Williams Co., 429 U.S. 569 (1977), the Supreme Court observed that the section 404 legislative history differed from section 267 - while section 267 focused on the timing of the income and deduction between certain parties, section 404 was enacted to assure that deferred compensation plans were funded for the benefit of the service providers. Thus, issuance of a note may be "payment" under section 267, but would not suffice for purposes of section 404.
Shortly after Truck and Equipment Corp. Of Harrisonburg, the Tax Court applied the temporary regulations to another set of facts (National Medical Financial Services, Inc., T.C. Memo 1992-178), again upholding the government. The fact patterns of the two cases are beyond the scope of this newsletter, but the two cited cases should be reviewed if a taxpayer/client anticipates being in violation of the 2½ month "bright line" test.
Also note that one year prior to these cases, a private letter ruling expanded the "plan to defer" provisions of IRC section 404 to preclude the accrual/deduction for payment of health benefits to the year "the amounts would be includible in the gross income of the (service provider) ... absent the exclusions under ... the Code", thus denying an "accrual" even where there was effectively no deferral of tax to the recipient (PLR 9112022). A test of that position in court may prove interesting.
If IRC sections 267 and 404 were the complete authorities on the timing of salary deductions, it would require due care to avoid the tax traps inherent among these provisions. Unfortunately, one need not reflect too extensively before realizing that there are other provisions which further affect the timing of salary deductions - among them certain "capitalizing" requirements, the economic performance rules under IRC section 461(h), and the "required payments" of electing Qualified Personal Service Corporations. But looking to the employee benefit plan provisions might be categorized as an accident waiting to happen
One recommendation - for annual clients who may end up being on extension next year with your next close encounter being after the 2½ month period has expired, you may wish to add a paragraph to the current tax transmittal letter advising them that certain payments (to shareholders and/or other service providers) must be made by appropriate target dates. Specifics applicable to the client or a "please call before year end" may round out such a paragraph.
RICHARD A. LAVINE, CPA You DO have a
email:lavine@taxacte.com "tax department"
tel: (818) 222-8752/fax: (818) 222-8755 and
- Available to tax professionals only research facilities
- For complimentary: (800) 829-2283 accessible in
[Tax Pros Only Please] "one-tenth hour" increments