Lonnie owns 100% of Quality Company’s common stock. Lonnie, the president of Quality, is a cash basis taxpayer. Quality is short of cash as of December 31, 2007, the close of its tax year. As a result, it is necessary to accrue a $50,000 bonus payable to Lonnie. As soon as the cash becomes available on January 15, 2008, Quality pays Lonnie the bonus in cash. When is the bonus deductible for the accrual basis corporation? How would your answer change if Lonnie is an accrual basis taxpayer?
Generally, an accrual basis corporation can deduct an expense in the tax year in which the payment is made to a cash basis taxpayer. However, because Lonnie and Quality are related parties, Quality must wait to deduct the expense until 2008, the tax year Lonnie reports the bonus as income. Quality will deduct the expense on its tax return for the year ended December 31, 2008 and Lonnie will report the bonus as income on his 2008 tax return. Note that the effect of the related party rule is to always have the income and the corresponding deduction reported in the same year.
If both Lonnie and Quality are accrual basis taxpayers, then Quality will accrue and deduct the bonus as an expense in 2007 and Lonnie will accrue the bonus as income in 2007.
