Year-End Bonuses: When the Deduction Lands
Why an accrual-method business can deduct a December bonus paid in March, the related-party rule that stops owners from doing the same, and the payroll tax on bonuses.
Reviewed by the Fairlight Accounting cross-border tax team — U.S. & Canadian Tax Desks
An accrual-method business can deduct a bonus in the year it is earned if the liability is fixed by year-end and the bonus is paid within two and a half months after year-end. Bonuses to more-than-50-percent owners of a C corporation, or to any S corporation shareholder, are deductible only when paid. A cash-method business deducts bonuses when paid.
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When is the deduction allowed?
| Business and recipient | Deduction year |
|---|---|
| Accrual method, bonus to an unrelated employee, paid within 2½ months after year-end (March 15 for a calendar year) | Year earned, if the liability was fixed at year-end |
| Accrual method, paid after the 2½-month window | Year paid |
| Accrual method, bonus to a related party (more than 50 percent owner of a C corporation; any S corporation shareholder; their family) | Year paid |
| Cash method, any recipient | Year paid |
What makes the liability fixed?
The all-events test: by year-end, the obligation must exist and the amount must be determinable. A bonus plan that lets the company cancel or reduce bonuses at its discretion before payment is not fixed. A pool that is fixed in total but allocated after year-end can qualify if the company is obligated to pay the whole pool, with any share forfeited by a departing employee reallocated to the remaining employees. Board resolutions and plan documents dated before year-end establish the facts.
How are bonuses taxed to the employee?
A bonus is supplemental wages. Federal withholding can be a flat 22 percent if the bonus is paid or identified separately from regular wages (a mandatory 37 percent on supplemental wages above $1 million for the year), or figured as if the bonus and regular wages were one payment when they are combined in a normal paycheck. Social Security and Medicare apply; an employee already over the 2026 Social Security wage base of $184,500 pays only Medicare. Bonuses paid in January count as the new year's wages for the employee regardless of when they were earned.
What about owner bonuses?
An S corporation shareholder's bonus is deductible when paid, and it must run through payroll as wages. Paying a large year-end bonus to a shareholder-employee can be part of setting reasonable compensation. For a C corporation owner, a bonus that pushes compensation above what is reasonable risks reclassification as a nondeductible dividend.
How do bonuses fit year-end planning?
A profitable accrual-method company can fix bonus liabilities in December and pay them in the first quarter, deducting them in the earlier year while employees are taxed in the later one. Compensation paid after the two-and-a-half-month window is deferred compensation, deductible only when the employee includes it in income, and it can fall under the Section 409A rules, which require advance documentation.
Frequently asked questions
Can I pay a bonus in cash or as a gift card to avoid payroll tax?
No. Cash and cash equivalents are wages regardless of form.
Does a bonus affect retirement plan contributions?
It is compensation for plan purposes unless the plan excludes bonuses, so it can increase both deferrals and employer contributions.
Can I deduct a bonus accrued to my spouse who works for the company?
A spouse of a related-party owner is a related party; the deduction waits for payment.
Is a bonus deductible if the employee has left before payment?
If each bonus required employment on the payment date and a forfeited bonus simply lapses, those bonuses were not fixed at year-end and are deductible when paid. If forfeited shares are reallocated within a pool the company must pay in full, the whole pool can still be deducted in the earlier year.
Official sources
The IRS explains: “Business expenses and interest owed to a related person who uses the cash method of accounting are not deductible until you make the payment and the corresponding amount is includible in the related person's gross income.” — Internal Revenue Service, Publication 538 (01/2022), Accounting Periods and Methods, https://www.irs.gov/publications/p538
The IRS explains: “The withholding rate on supplemental wages remains 22% (37% if supplemental wages paid to an employee during the calendar year exceed $1 million) because P.L. 119-21 permanently extended the individual tax rates enacted in P.L. 115-97.” — Internal Revenue Service, Publication 15 (2026), (Circular E), Employer’s Tax Guide, https://www.irs.gov/publications/p15
Next step
Fairlight Accounting handles U.S. domestic, cross-border (U.S.–Canada), and international tax returns, plus bookkeeping, payroll, and CFO advisory. Our U.S. Tax Desk documents bonus liabilities before year-end so the deduction holds in the earlier year. See pricing or book a free fit call.
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