When businesses decide on year-end bonus accruals, they’re setting aside a future liability in December, even when actual payment comes later.

For accrual-basis taxpayers, that accrual can often still qualify as a 2025 tax deduction, provided certain IRS rules and timing requirements are met. That’s why the timing of accrual and payment is a crucial decision with significant cash flow and tax implications.

The 2.5-month rule is a crucial component of this strategy: for calendar-year businesses, bonus amounts accrued by December 31, 2025, can still be deducted on the 2025 tax return if payment is made by March 15, 2026.

That March 15, 2026, deadline gives an opportunity for operations and cash management but also imposes discipline on accrual documentation, board approvals, and payroll execution.

In this guide, we will shed light on how the 2.5-month rule works, including best practices to maximize your bonus accruals.

What Is a Bonus Accrual?

A bonus accrual is an accounting entry that recognizes a future bonus liability in the period when the bonus is earned, even if payment will be made later. In accounting (and tax) terms, bonus accrual ensures expenses are matched to the period in which the underlying employee performance occurred, rather than when the cash changes hands.

From the tax perspective, the accrual is only meaningful if the liability becomes fixed and determinable by year-end, and if payment is made within certain timing rules (such as the 2.5-month rule).

Difference between Cash-Basis and Accrual-Basis

Cash-basis taxpayers deduct expenses only when cash is paid. If you’re a cash-basis business, you can’t deduct a bonus until you actually disburse it, even if the bonus was earned in a prior year.

Accrual-basis taxpayers can (with care) recognize bonuses as deductions in the year earned if certain criteria are met: the liability is fixed, the amount is reasonably determinable, and payment is made within the allowed window (e.g., 2.5 months).

Since many modern companies, and HR/payroll operations like Chore’s clients, work with scheduled or off-cycle pay runs (say, for bonuses or commissions), understanding which accounting method you use is important for proper timing.

When Is an Accrued Bonus Deductible?

For an accrual-basis employer, an accrued bonus becomes deductible in the tax year of accrual if:

• The liability is fixed and determinable by year-end (i.e., all events establishing the obligation have occurred).
• The bonus is paid (or constructively paid) within 2½ months after year-end (for calendar year taxpayers).

If these conditions are not met, the deduction is disallowed until the year the bonus is paid.

For instance, consider these scenarios:

Scenario 1: January Payment

A company accrues a $50,000 bonus on December 31, 2025 (liability is fixed and determinable). In February 2026, it pays the bonus. Since payment is within 2½ months, the business may deduct that $50,000 on its 2025 return (assuming other rules, such as non-related parties, are met).

Scenario 2: March Payment (late)

If instead the payment occurs in mid-April 2026 (beyond the 2½-month window), the deduction cannot be claimed in 2025. The expense must wait and be deducted in 2026, when the bonus is paid or constructively received.

These timing differences can affect taxable income, cash flow planning, and financial statement presentation.

What is the 2.5-Month Rule?

The 2.5-month rule is an important exception under the tax code that allows certain accrued compensation (like year-end bonuses) to remain deductible in the year earned, even if paid after year-end.

To understand it, let’s start with the governing statutes and regulations.

Legal Foundation: IRC § 404(a)(5) and Treas. Reg. § 1.404(b)-1T

Under IRC § 404(a)(5), compensation paid or accrued under a plan that defers the receipt of compensation is generally not deductible until the taxable year in which the employee includes the amount in income.

In other words, amounts paid after the year of accrual are treated as deferred compensation and cannot be deducted earlier.

Treasury Regulation § 1.404(b)-1T provides an exception: if the payment of the accrued compensation occurs within the first 2.5 months after the employer’s year-end, the payment is not deemed deferred compensation for purposes of IRC § 404, and thus remains deductible in the accrual year (subject to other tests).

In effect, the regulation “opts out” accruals paid within that 2.5-month window from being treated as deferrals, thus preserving the earlier deduction timing.

What Is the “2.5 Months After Year-End” Window?

For calendar-year taxpayers (i.e., year-end December 31), the 2.5-month window extends through March 15 of the following year. Any accrued compensation for services rendered in 2025 that is paid by March 15, 2026, qualifies under that window.

If you miss that cutoff (i.e., pay on March 16 or later), the payment is treated as deferred compensation under § 404(a)(5) and cannot be deducted in 2025; instead, it must be deducted in the year the employee includes it in income (usually when paid).

For non-calendar fiscal years, the same 2.5-month rule applies, counting from the fiscal year-end date.

Application of the 2.5-Month Rule

Accrued Bonuses

If a company determines a bonus formula by year-end (e.g., 10% of profits, or a predetermined amount per employee) and accrues it on December 31, payment by March 15 qualifies under the rule.

Commissions

For sales-based commissions, if by year-end the trigger and amount are known and calculable, payment within 2.5 months keeps the deduction in the accrual year.

Vacation Pay/ Paid Time Off

Electing to accrue vacation liability must be done under the applicable vacation pay rules. In certain cases (if not governed by a “welfare benefit fund”), § 404 and § 1.404(b)-1T extend to methods that defer compensation.

However, the Treasury’s regulations and interpretations note that section 463 may govern vacations if the employer has elected under that code section. This means the 2.5-month rule might not always apply to every vacation accrual.

Which Businesses Qualify to Use the 2.5-Month Rule?

Not every business can take advantage of the 2.5-month rule for bonus accruals. Eligibility depends on the method of accounting and related-party restrictions under IRC § 267(a)(2). Here’s a breakdown of who qualifies and who does not:

Accrual-Basis Taxpayers Only

To use the 2.5-month rule, the business must employ the accrual method of accounting. Under accrual accounting, expenses are recognized when incurred (if all events have occurred and the amount is fixed or determinable), even if payment happens later.

On the other hand, cash-basis taxpayers cannot accrue a bonus for deduction until the payment is actually made. A cash-basis business must wait until the cash leaves the bank before claiming the deduction.

As a result, only accrual-basis C corporations, S corporations, and partnerships (or LLCs taxed as partnerships) may potentially qualify to apply the 2.5-month rule.

Business Type: C Corps, S Corps, Partnerships

C corporations (accrual basis) can accrue and deduct bonuses paid to employees, provided the 2.5-month payment window is met.

S corporations (accrual basis) may also qualify, but face stricter constraints under related-party rules, especially because S corp shareholders are treated as related parties.

Partnerships (or LLCs taxed as partnerships) on an accrual basis also can use accrual deductions, including bonuses, provided the liability is fixed by year-end and payment falls within the required period.

Related-Party Rule Under § 267(a)(2)

Bonuses payable to related parties often cannot be deducted under the accrual method until the payee actually includes the income (i.e., you must “match” the deduction to when they report it). This is mandated by IRC § 267(a)(2).

Important points to note under § 267(a)(2) include:

• If the payee (e.g., a shareholder, partner, or relative) uses the cash method of taxation (as many individuals do), the deduction must be deferred until that person reports income.
• In the case of an S corporation, § 267(e)(1)(B)(ii) treats the S corp and any shareholder (direct or indirect) as related for deduction timing purposes, regardless of the amount of stock held.
• For C corporations, accrued bonuses to a controlling shareholder (owning > 50 %) may also be disallowed or deferred if the shareholder is on a cash method as of the accrual date.
• “Related parties” include family members (spouse, children, siblings, ancestors) and entities with common ownership under the rules of § 267(b).

Thus, a bonus accrual may qualify under the 2.5-month rule only if the payee’s income recognition and method of accounting align with the deduction timing under § 267.

Here’s a table illustrating the eligibility conditions:

When Bonuses Must Be Paid to Keep the Deduction

Payment timing is important to keep your 2025 bonus accrual deduction. Below is what you must know about deadlines, special rules, and how the IRS treats “payment” under the doctrine of constructive receipt.

Payment Deadline for Calendar-Year Taxpayers

If your company operates on a calendar-year basis and accrues bonuses in 2025, you must pay those bonuses no later than March 15, 2026, to deduct them in the 2025 tax year (via the 2.5-month rule). If they’re paid after that, the deduction moves into 2026.

Fiscal-Year Entities

For a company using a fiscal year (e.g., ending June 30), the 2.5-month window applies relative to the fiscal year-end. For instance, if your fiscal year ends June 30, 2025, you must pay accrued bonuses by September 15, 2025, to deduct them in that fiscal year.

Always count 2.5 months (which means the 15th of that month) from the fiscal year-end to find your “deadline.”

Constructive Receipt

The IRS doesn’t only look at when the cash hits the employee’s hands; it also applies constructive receipt. This treats the bonus as “paid” if the employee can demand or control receipt, even if the funds haven’t been physically delivered.

So even if you mail a check late in March, if the employee could have accessed the funds earlier (for example, if the check was made available earlier), you risk failing the test. The most important thing is that the payment must actually be made (or made available without control issues) within the 2.5-month window.

Documentation Requirements and Best Practices for Compliance

Here are the practices and records you should maintain to support your deduction and demonstrate bonus accrual compliance:

Board Resolutions, Payroll Records and Accrual Journal Entries (Pre–Year-End)

Long before December 31, you must establish the liability on your books. That means:

• Pass a formal board or management resolution authorizing the amount of the bonus pool and approving accruals.
• Record the accrual via journal entries dated as of December 31, 2025 (e.g., debit “Bonus Expense,” credit “Accrued Bonus Payable”).
• Maintain comprehensive payroll records (timesheets, payroll summaries, employee rosters) that tie into the accrual without gaps or inconsistencies.

These steps show the liability was recognized before year-end, not after. If the IRS questions the deduction, they’ll expect to see that the company committed to the obligation before January 1.

Evidence That Bonus Was “Determinable” by December 31

To pass the test under IRC § 461 and related regulations, the amount must be fixed and determinable by year-end. You should document:

• The methodology or formula used (for instance, “10% of year-end profits,” or tiers tied to performance metrics).
• Any supporting internal memos, emails, or reports showing calculations completed before year-end.
• A written bonus plan or employment agreement stating how amounts are computed, so that future audits see it wasn’t arbitrary or tentative.

Evidence of Actual Payment by the Deadline

To keep the 2025 deduction, you must prove that the accrued bonus was paid within 2.5 months of year-end. Useful records include:

• Copies of checks, bank transfer confirmations, or payroll system reports showing disbursement dates.
• Remittance records, canceled checks, or statements reflecting the outgoing payments.
• Payroll tax filings or W-2/1099 reports confirming the compensation was included in payee income in that year.

Written Bonus Plan or Employment Agreement

A well-drafted bonus policy or employment agreement is important in keeping your deductions. It helps:

• Show that the fiscally binding intent and formula were established ahead of time.
• Prevent IRS claims that bonuses were ad hoc or discretionary.
• Provide independent support beyond internal journal entries.

If your bonus plan is clear and consistent with payroll practices, it strengthens your position before an examiner.

How to Maximize Year-End Bonus Deductions

Here are 5 proven strategies to help you stay on the right side of the IRS and optimize your bonus deductions:

Plan Bonuses Early to Lock in Board Approval and Accruals by December 31

Well before year-end, propose your bonus plan to your board or compensation committee. The liability must be fixed and determinable by December 31 to qualify. That means you should decide and document who gets a bonus, how much, and based on what criteria before year-end.

Waiting until January or February can jeopardize your ability to accrue the expense in 2025. Accrual-basis taxpayers can deduct employee bonuses accrued by December 31 so long as they are paid within 2.5 months after year-end.

Use “Performance-Based” Bonuses with Fixed Criteria

To satisfy the IRS’s “all events” and “fixed and determinable” tests, tie bonus amounts to objective performance metrics (e.g., sales volume, project completion, margin targets). Avoid bonuses contingent on factors still unknown as of December 31 (e.g., discretionary future events). If the formula is set in advance, you build a defensible position for the deduction.

Set Internal Payment Reminders Before March 15

Set internal deadlines; at least two reminders (e.g., February 28 and March 7), to ensure bonus payments are processed no later than March 15, 2026 (for calendar-year entities). Treat this as a nonnegotiable compliance event, like your tax-filing deadlines.

Use Payroll Software or EFTPS Scheduling for Automation

Manual processes are error-prone. Instead, automate bonus payments using payroll systems or the IRS’s Electronic Federal Tax Payment System (EFTPS). Many modern payroll platforms allow you to schedule supplemental wage payments in advance. This automation minimizes the risk of missing the 2.5-month cutoff.

Coordinate Closely with Your Tax Advisor and Accountant

Your tax advisor should be involved from planning through execution. They should review your accrual entries, documentation, bonus formulas, and payment process. During this collaboration, you can confirm eligibility, resolve edge-case issues (e.g., bonuses to related parties), and help you withstand IRS scrutiny.

Automate Year-End Bonus Payments and Stay Compliant with Chore

Startups experiencing rapid growth shouldn't gamble with tax deductions. Chore's payroll automation platform ensures your year-end bonuses hit the March 15 deadline, every time.

Here's how Chore solves the 2.5-month rule challenge:

• Set It and Forget It: Schedule bonus payments in advance through Chore's platform. Our system automatically processes payments within your compliance window, eliminating manual tracking errors that cost startups thousands in lost deductions.
• Built-in Compliance Alerts: Chore flags related-party payments (shareholders, family members) that could trigger IRC § 267 issues, protecting you from disallowed deductions before they happen.
• Documentation Made Easy: Every bonus payment generates audit-ready records; bank confirmations, payroll reports, and W-2 documentation, organized in one dashboard.
• Seamless Board Approval Integration: Link bonus authorizations directly to payment execution, ensuring your accruals are truly "fixed and determinable" by December 31.

While competitors offer basic payroll, Chore delivers strategic tax optimization. Our clients preserve an average of $47,000 in year-end deductions by automating bonus timing and compliance.

Ready to lock in your 2025 deductions? Schedule a demo and see how Chore turns complex tax rules into an automated competitive advantage.

FAQs

What is the 2.5-month rule for bonus accruals?

The 2.5-month rule for bonus accruals is an IRS tax rule that allows accrual-basis businesses to deduct employee bonuses in the tax year they were earned (even if the bonuses are paid after year-end) as long as payment is made within 2 1⁄2 months after the close of that tax year.

How do I prove my bonus liability was fixed by year-end?

To prove your bonus liability was fixed by year-end, you need clear documentation showing that the obligation existed on or before December 31 and was not discretionary:

• Adopt a written bonus plan or board resolution before December 31, detailing who qualifies, how amounts are calculated, and when they’ll be paid.
• Make the bonus amount determinable. Use a fixed formula (e.g., percentage of salary or profit) to meet the IRS “all-events” test.
• Avoid discretionary bonuses. If management can change or cancel bonuses after year-end, they’re not deductible.
• Record the accrual in your books. Post the expense and liability by December 31.
• Keep solid documentation. Include meeting minutes, payroll records, and accrual entries to prove the liability was binding at year-end.

How does the IRS test whether a bonus is “determinable”?

The IRS tests whether a bonus is “determinable” using the all-events test. To qualify for a deduction under the 2.5-month rule, the employer’s liability must be fixed and the amount reasonably ascertainable by year-end.

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