Accrued Bonus 2.5 Month Rule: Fixed Liability and Related Parties

If your business uses accrual accounting and books a bonus at year-end, you can deduct that bonus in the accrual year only when the employee actually receives payment within two and a half months after the year closes. That is the accrued bonus 2.5 month rule under Section 404 of the Internal Revenue Code, and for a calendar-year business the deadline is March 15. Pay on March 16 and the deduction moves to the following year. The deadline is only half of it: the underlying liability also has to be fixed before year-end, and bonuses paid to owners or family members face a second matching rule that can override the timing entirely.

How the 2.5 Month Deadline Works

Section 404 treats a bonus accrued in one year and paid in the next as deferred compensation, deductible only when the employee includes it in income.¹ That would defeat the whole purpose of a year-end accrual. The Treasury Regulations carve out an exception: if the employee actually receives payment by the 15th day of the third calendar month after the employer’s tax year ends, the bonus escapes deferred-compensation treatment and the accrual-year deduction stands. For a December 31 year-end, that means March 15. A June 30 fiscal year gets until September 15.

There is no extension, no reasonable-cause exception, and no rounding. A bonus accrued on December 31, 2025, and paid on March 16, 2026, is not deductible in 2025.

The Liability Has to Be Fixed by Year-End

Before the 2.5 month clock even matters, the accrual itself has to survive the all events test. An accrual-basis taxpayer can deduct a bonus for the year only if two things are true by the end of that year: the liability is fixed, and the amount can be determined with reasonable accuracy.² Economic performance also has to have occurred, which for services means the employee has already done the work.³

Whether the liability is truly fixed depends on how the bonus plan is structured. Two approaches work:

A bonus calculated by a formula set before year-end using that year’s financial results creates a fixed liability, even if individual allocations happen later.
A board resolution or compensation committee action before year-end that commits the company to pay at least a specified total to a group of employees also fixes the liability.

In Revenue Ruling 2011-29, the IRS held that an employer’s obligation was fixed at year-end because the bonus pool could not revert to the company. Individual recipients were not identified until after December 31, but the minimum total was locked in by a pre-existing formula, and any amount forfeited by a departing employee was reallocated to others in the group.⁴

A purely discretionary bonus, where management can still decide to pay nothing after year-end, fails the test. Without a formula or a binding commitment in place by December 31, no current-year deduction is available regardless of when payment happens.

The Continued Employment Trap

This is where most accrued bonus deductions come apart. Many plans require the employee to still be on the payroll when the check is cut. That “must be employed on the payment date” clause is a contingency, and it keeps the liability from being fixed at year-end. In Chief Counsel Advice 200949040, the IRS concluded that when a plan conditions payment on continued employment, the employer does not yet know at year-end whether it owes the bonus at all. The liability becomes fixed only when the employee satisfies the condition on the payment date itself.

The saving grace is a reallocation provision. If forfeited amounts get redistributed to other eligible employees rather than returning to the company, the total pool is still owed and the all events test can be met, as Revenue Ruling 2011-29 confirmed.⁴ Without that mechanism, a “still employed” clause pushes the deduction to the year of payment no matter how quickly the check goes out.

What Counts as Payment

Section 404(a)(11) sets a stricter standard than most cash-method rules: no amount is treated as paid until the employee actually receives it.¹ Constructive receipt is not enough. Funds credited to an internal account, entries on the payroll register, or a check sitting in a drawer will not satisfy the deadline, even though those same events might count as income for a cash-method taxpayer under the ordinary rules.⁵

The employee has to have the money in hand or in an account. Mail a check so close to the deadline that it arrives on March 16, and the accrual-year deduction is gone. Direct deposit or wire transfer creates the cleanest record of when the funds actually reached the recipient.

Bonuses to Owners and Family Members Face a Second Rule

The 2.5 month rule under Section 404 applies to every employee bonus. When the recipient is a related party who uses the cash method, Section 267(a)(2) piles on: the payer’s deduction is allowed only in the year the recipient includes the payment in income.⁶ The deduction and the income recognition must land in the same year.

For a calendar-year business paying a related cash-method owner, the two rules work together. Pay by March 15 and the business deducts the bonus in the accrual year while the owner reports it as income in the payment year. Miss March 15 and Section 404 turns the bonus into deferred compensation while Section 267(a)(2) locks the deduction to the year the owner actually receives the cash.

Who Counts as a Related Party

Section 267(b) lists the relationships that trigger these stricter rules. The ones that most often catch closely held businesses:⁶

Family members, including a spouse, siblings (including half-siblings), parents, grandparents, children, and grandchildren. Legally adopted family members count.
An individual and a corporation, when the individual owns more than 50% of the corporation’s stock by value, directly or indirectly.
A partnership and a partner who owns more than 50% of the capital or profits interest.
A personal service corporation and any employee-owner, regardless of the ownership percentage that would otherwise apply.

Section 267(c) then attributes ownership between family members and through entities, and the attributed ownership counts as real ownership for the 50% test. Consider a corporation owned 30% by a father and 30% by his daughter. Neither owns more than half directly, but each is treated as owning the other’s 30% through family attribution. Both cross the 50% line, both are related parties, and any bonus accrued for either of them has to clear the March 15 deadline to preserve the current-year deduction. Businesses often trip this wire without realizing the attribution rules have pushed them over the threshold.

What Happens When You Miss March 15

Missing the deadline does not kill the deduction. It defers it. Under Section 404(a)(5), the bonus becomes deferred compensation and the employer deducts it only in the year the employee actually receives payment and includes it in income.¹ A $50,000 bonus accrued on December 31, 2025, but paid in April 2026 becomes a 2026 deduction. A full year of tax benefit slides away.

For related parties, Section 267(a)(2) says the deduction is allowed only “as of the day” the amount is includible in the recipient’s gross income, reinforcing the same result and guaranteeing that payer and payee are taxed in the same period.⁶

Section 409A Penalties Fall on the Employee

The lost deduction is the employer’s problem. A missed deadline can also become the employee’s problem. The 409A regulations include a short-term deferral exception: compensation paid by the 15th day of the third month after the year in which the right to payment stops being subject to a substantial risk of forfeiture is not treated as deferred compensation for 409A purposes.⁷

Miss that window and the bonus can fall inside Section 409A. If the plan does not comply with 409A’s distribution timing and election rules, the deferred amount becomes immediately includible in the employee’s gross income, plus a 20% additional tax, plus an interest charge at the underpayment rate plus one percentage point running back to the year the compensation was first deferred.⁸ A late bonus can turn into a tax penalty on the person who earned it.

Documentation That Holds Up Under Examination

An IRS examiner reviewing an accrued bonus deduction wants to see that the liability was fixed before December 31 and that payment actually reached each recipient before the deadline. Useful records include:

A board resolution or written formula adopted before year-end, showing the total pool or a minimum committed amount that cannot revert to the company.
Plan terms without disqualifying contingencies. If continued employment is required, include a reallocation provision so forfeited amounts go to other eligible employees.
Proof of actual receipt: bank records, direct deposit confirmations, or cleared-check dates showing funds reached each employee by March 15. A payroll processing date is not the same thing.
Workpapers tying each accrued amount to a specific recipient, payment, and date, so the connection between the year-end liability and the cash disbursement is documented.

For closely held businesses paying bonuses to owner-employees, the amount also has to qualify as reasonable compensation under Section 162. Clearing the 2.5 month deadline secures the timing; it does not save a deduction for an amount that exceeds what the services were worth.

1
Office of the Law Revision Counsel. 26 USC 404 – Deduction for Contributions of an Employer
2
Internal Revenue Service. Publication 538 (01/2022), Accounting Periods and Methods
3
Office of the Law Revision Counsel. 26 USC 461 – General Rule for Taxable Year of Deduction
4
Internal Revenue Service. Revenue Ruling 2011-29
5
eCFR. 26 CFR 1.451-2 – Constructive Receipt of Income
6
Office of the Law Revision Counsel. 26 USC 267 – Losses, Expenses, and Interest With Respect to Transactions Between Related Taxpayers
7
eCFR. 26 CFR 1.409A-1 – Definitions and Covered Plans
8
Office of the Law Revision Counsel. 26 USC 409A – Inclusion in Gross Income of Deferred Compensation Under Nonqualified Deferred Compensation Plans