The executive order concerning the deferral of employee payroll taxes has garnered significant attention, but there is another payroll tax deferral that could carry unintended consequences for employers. The Coronavirus Aid, Relief, and Economic Security (CARES) Act and the Paycheck Protection Program Flexibility (PPFA) Act allow employers, including those who received a PPP loan, to defer payment on the employer’s share of Social Security taxes (6.2% of wages) that would have otherwise been due between March 27, 2020 and Dec. 31, 2020. Employers must pay 50% of the amount deferred by Dec. 31, 2021 and the remaining 50% by Dec. 31, 2022. This allows cash and accrual method businesses to retain funds needed for other purposes, but it will also impact the 2020 tax deduction for these businesses.
Cash Method Businesses
Cash method businesses deduct expenditures generally when cash payments are made. This principle applies equally to items like office expenses, utilities, and payroll taxes. Cash method taxpayers that defer payment for payroll taxes to any point after Dec. 31, 2020 lose the payroll tax deduction for 2020, because the deduction is pushed to the later year(s) when the tax is paid. If the 2020 tax deduction is critical, these businesses might consider payment of some or all of the deferred payroll taxes ahead of time. But that would mean the business must pay the deferred payroll taxes at least 12 months early, an unsavory prospect for most.
Accrual Method Businesses
For accrual method taxpayers, payment after the end of 2020 may not necessarily result in a loss of the deduction for 2020, but some planning and compromise is necessary to accomplish that objective. Under the “recurring item exception,” payment of the deferred payroll tax by the earlier of the time the tax return is filed or Sep. 15, 2021 (for calendar year filers) will make the payroll tax deductible for 2020. This means the deferred payroll taxes must be paid at least 3 ½ months early – a compromise to be sure – but arguably a small one.
For accrual method taxpayers, the recurring item exception is one of the exceptions to the economic performance prong of the all-events test. Under the all-events test, an item is not deductible until all three prongs of the test have been met:
- The fact of the liability has been established;
- The amount of the liability can be determined with reasonable accuracy; and
- Economic performance has been completed by the last day of the tax year.
In the case of payroll taxes the first two prongs are met, as the liability and the tax rate are both established by law. The IRS favorably resolved some nettlesome issues on these first two prongs in Rev. Rul. 2007-12 and Rev. Rul. 96-51, pertaining to deferred compensation and FICA tax ceilings that are beyond the scope of this article. That means only the third prong needs to be addressed.
In the case of taxes, the third prong is met through payment. So absent an exception, the third prong of the test for a “payment liability” – such as payroll taxes – will never be met by the last day of the tax year unless payment is made by that time. This is where the need for the recurring item exception arises.
Under the recurring item exception, economic performance is deemed to occur by the last day of the tax year, provided each of the following conditions is satisfied:
- Economic performance occurs within the shorter of a reasonable period after the close of the tax year (i.e., the time the taxpayer files a timely return) or 8 ½ months after the close of the tax year;
- The item must be recurring in nature and the taxpayer must consistently treat similar items in the same manner; and
- The expense must not be material, or the accrual of the expense in the tax year must result in better matching.
Most employers on the accrual method are already using the recurring item exception for payroll taxes, so accounting method change requests to adopt the recurring item exception for payroll taxes should not be required in most scenarios. Moreover, any amount of payroll taxes paid after the end of a tax year on account of wages paid during the previous tax year would not be deductible without the recurring item exception. So unless a taxpayer routinely experienced book to tax differences on payroll taxes in the past (unlikely), the taxpayer is already utilizing the recurring item exception for payroll taxes.
This sets the stage for a taxpayer’s planning to take advantage of the recurring item in the case of deferred payroll taxes. Payroll taxes are clearly recurring in nature, and the accrual of the tax in the current tax year also reflects better matching to the associated payroll costs. With these conditions satisfied, a taxpayer needs only to pay the payroll taxes by the earlier of the tax return filing date or 8 ½ months after the close of the tax year. In the case of employer payroll taxes deferred under the CARES Act, this means paying the payroll taxes at least 3 ½ month early, but doing so will accelerate a tax deduction into the current tax year.
With proper planning, an accrual method taxpayer can accelerate some or all of payroll taxes deferred under the CARES Act to 2020; however, the benefit of doing so is rather small. Unlike many other types of temporary differences on the timing of tax deductions, the timing of the deduction for deferred payroll taxes involves a relatively short window. For many other types of temporary differences (such as those that will not reverse for a very long time), the tax benefit for an accelerated deduction has a quasi-permanent nature.But in the case of an accelerated deduction for deferred payroll taxes, the tax deduction is potentially accelerated by only one to two years, which is beneficial but must be understood as a time value of money and tax rate analysis.
For more information on the employer’s deferral of payroll taxes and planning opportunities to accelerate the associated tax deductions, please contact us.
Published on October 23, 2020