Year-End Bonus and Severance Accruals: Deduct Them This Year Only If You Pass Two Tests

You closed the books on December 31 with $180,000 of employee bonuses accrued and deducted — then paid them in April. On audit, the IRS disallows the entire deduction for that year and pushes it into the next one. Nothing about the bonuses was fake: the employees earned them, the amounts were right, and the cash went out. What failed was the timing. For accrual-basis employers, deducting compensation you have not paid yet means passing two separate gates, and missing either one moves your deduction a full year forward.

The same two gates decide when you can deduct accrued severance. This guide walks through both, explains why discretionary bonus pools routinely fail the first gate, and shows how to book the accruals so your ledger tells the true story.

The Two Gates at a Glance​

Every deduction for unpaid year-end compensation must clear both of these:

1. The all-events test (Section 461): by December 31, all events fixing the fact of your liability must have occurred, the amount must be determinable with reasonable accuracy, and economic performance must have taken place.
2. The 2-1/2-month payment rule (Section 404): the employee must actually receive the money within 2-1/2 months after your year-end — March 15 for a calendar-year employer. Miss that window and the bonus becomes deferred compensation, deductible only in the year the employee reports it as income.

These are independent requirements. A bonus that satisfies the all-events test but is paid on April 1 fails. A bonus paid on February 15 under a plan that left everything to the board's later discretion also fails. Plan for both from the start.

Gate 1: The All-Events Test​

The all-events test has three prongs, and bonus plans tend to stumble on the first and third.

The fact of the liability must be fixed​

By year-end, your obligation to pay must be fixed — not contingent on something that happens later. The classic failure is a still-employed condition: the plan says employees earn the bonus through their year-end performance but forfeit it unless they are still on the payroll when checks go out in February. Because someone could quit in January and extinguish your obligation, the liability is contingent at December 31. IRS Chief Counsel reached exactly that conclusion in published guidance (CCA 200949040): a bonus conditioned on employment at the year-2 payment date cannot be accrued in year 1.

Board discretion is the other common killer. If the bonus pool exists only as a target and the board does not approve actual payouts until it sees audited results in February, there is no fixed liability at year-end — just an intention. The deduction waits until the year the discretion is exercised.

The amount must be determinable with reasonable accuracy​

You do not need the number down to the penny, but you need a real computation, not a guess. A formula fixed before year-end — say, 8 percent of operating profit above a threshold the final trial balance already determines — satisfies this prong. A round-number reserve with no supporting calculation does not.

Economic performance must have occurred​

For compensation, economic performance generally means the employee performed the services. When the bonus rewards services already rendered during the year, this prong is met. But a still-employed condition infects this prong too: the IRS position is that requiring continued service into year 2 means economic performance is incomplete at year-end, because the liability depends on services not yet performed.

Why Discretionary Pools Fail — and How Pooled Plans Can Pass​

Many small businesses run bonuses as a discretionary pool: ownership decides after year-end how big the pool is and who gets what. That arrangement fails the all-events test twice over — the fact of the liability is not fixed (the board could award zero) and the amount is not determinable. The deduction belongs to the payment year, not the accrual year.

But a pooled arrangement is not automatically doomed. In Revenue Ruling 2011-29, the IRS blessed a structure in which the employer fixed the total bonus amount by formula or corporate action before year-end, even though it did not know which employees would receive what until after year-end. The key design feature: amounts allocable to employees who left before the payout date were reallocated among the remaining eligible employees, so the employer's total obligation never depended on any individual's continued employment. The fact of the liability was established for the group, and the deduction held in year 1.

The practical lesson for your plan document:

• Fix the amount before year-end with a formula tied to numbers your year-end close determines, or with a written board resolution adopted on or before December 31.
• Remove individual contingencies from the total by providing that forfeited shares are reallocated to remaining participants rather than reverting to the company.
• Document it. Board minutes, a signed plan memo, and the calculation worksheet are what you hand the examiner. A formula nobody wrote down is, for audit purposes, discretion.

Gate 2: The 2-1/2-Month Payment Rule Under Section 404​

Even a perfectly fixed liability becomes deferred compensation if you pay it too late. Under Section 404 and the temporary regulation at 1.404(b)-1T, compensation is treated as part of a deferred compensation plan unless the employee actually receives it by the 15th day of the third calendar month after the end of your tax year — March 15 for calendar-year employers.

Three details catch people:

• Actually received, not constructively received. A check dated March 14 that the employee picks up March 20 may not count. The money must be in the employee's hands by the deadline.
• Late payment does not destroy the deduction — it delays it. Bonuses paid after the window are deductible in the year the employee includes them in income, which is normally the payment year. You lose a year of time value, and your book-tax difference report gets a new line item.
• The same window exempts the plan from Section 409A. Bonuses paid within 2-1/2 months of year-end (or of the vesting date, if later) fall under the short-term deferral exception to the nonqualified deferred compensation rules. Miss the window and you may inherit 409A documentation and penalty exposure on top of the timing problem.

Calendar-year employers should treat March 1, not March 15, as the internal deadline — payroll processing, bank holidays, and a missed direct-deposit cutoff have pushed many well-designed plans over the line.

Severance Accruals Face the Same Two Gates​

Severance raises the same questions with a different fact pattern. An employer that commits to severance terms in December but pays the departing employee over the following year wants the deduction now. Whether that works depends, again, on both gates.

All-events test. The liability must be fixed by year-end. A general severance policy promising "up to twelve weeks at management's discretion" fixes nothing. A signed separation agreement executed in December, or a communicated termination plan naming the affected employees and the benefit formula, can fix the liability — the triggering event (the termination decision and its communication) has occurred. As with bonuses, amounts conditioned on future events, such as refraining from competition over the payout period where forfeiture returns the money to the company, are contingent and wait.

The 2-1/2-month rule. This is where most severance accruals fail. Severance paid as salary continuation over six or twelve months necessarily stretches past March 15, making it deferred compensation under Section 404(a)(5): deductible only as the former employee includes each installment in income. Only severance actually paid within the window escapes that treatment. Lump-sum severance paid in January or February for a December termination can qualify; a twelve-month payout stream cannot, no matter how airtight the agreement.

The book-tax split this creates is normal and expected: your financial statements recognize the full severance expense when the liability is probable and estimable, while your tax return deducts it check by check. Track the difference on a deferred-tax schedule rather than letting it surprise you at provision time.

Booking Bonus and Severance Accruals in Your Ledger​

Accrual accounting exists precisely for this situation: the expense belongs to the year the obligation arose, even though the cash leaves later. The entries are straightforward.

At December 31, record the accrued bonuses:

2026-12-31 * "Accrue FY2026 employee bonuses per plan formula" #year-end #bonus-accrual
  Expenses:Payroll:Bonuses         180,000.00 USD
  Liabilities:Accrued-Bonuses     -180,000.00 USD

When you pay them in February, relieve the liability rather than expensing again — the classic double-count to avoid:

2027-02-15 * "Pay FY2026 bonuses via payroll" #year-end #bonus-accrual
  Liabilities:Accrued-Bonuses      180,000.00 USD
  Assets:Checking                  -180,000.00 USD

Severance follows the same pattern, with its own accounts so the payout stream stays visible:

2026-12-20 * "Accrue severance per signed separation agreement" #severance
  Expenses:Payroll:Severance        48,000.00 USD
  Liabilities:Accrued-Severance    -48,000.00 USD
 
2027-01-15 * "Severance installment 1 of 6" #severance
  Liabilities:Accrued-Severance      8,000.00 USD
  Assets:Checking                   -8,000.00 USD

Two bookkeeping disciplines pay for themselves here. First, reconcile the accrued-compensation liability accounts to the supporting schedules every month — an accrual that sits unreconciled is how a March 15 deadline gets missed. Second, tag the tax-sensitive attributes (payment dates, still-employed conditions, discretionary versus formula amounts) in narration or metadata while the facts are fresh; reconstructing them during an exam two years later is how foot faults turn into adjustments.

Mistakes That Move Your Deduction a Year Forward​

• Approving the pool in February and accruing it in December. If the board's vote creates the obligation, the obligation arises in the vote year.
• Keeping a still-employed clause in the plan. It feels prudent — why pay quitters? — but it makes the whole accrual contingent. Reallocate forfeitures instead.
• Confusing a book reserve with a tax accrual. Your auditors may accept a well-supported estimate; the all-events test demands a fixed liability. The two standards diverge most on discretionary amounts.
• Paying on March 16. Or dating the check March 14 and mailing it March 20. Actual receipt by the deadline is the rule.
• Assuming severance paid over time is deductible when accrued. Salary continuation is deferred compensation. Deduct it as paid.
• Forgetting state conformity. Most states follow the federal timing rules, but a few decouple on deferred compensation provisions. Confirm your state's treatment before finalizing the provision.

Your Before-Year-End Checklist​

December is when this year's deduction is won or lost. Before the ball drops:

1. Put the bonus formula in writing, tied to metrics your year-end close will determine, and adopt it by board action dated on or before December 31.
2. Strip individual contingencies from the employer's total obligation, or accept that the deduction waits until the payment year.
3. Prepare the calculation worksheet showing the accrued amount with reasonable accuracy, and keep it with the board minutes.
4. Schedule payment for February, leaving a buffer before the March 15 statutory deadline.
5. Execute separation agreements before year-end for any severance you intend to accrue, and calendar each installment's tax year for the provision.
6. Reconcile accrued-compensation accounts to the penny at the January close, so nothing falls through the gap between the ledger and the return.

Year-end compensation accruals reward employers who fix obligations early and pay promptly — and punish vague plans and slow payrolls with a year-long deduction delay. Get the formula signed, the conditions cleaned up, and the cash out by mid-March, and the deduction stays where it belongs.