S-Corp Accrued Bonus Deduction: The Related-Party Trap
If your S-corp runs on the accrual method and books an accrued bonus to a shareholder at December 31, don’t assume you get the deduction for that year just because you cut the check in January. Section 267 of the tax code treats an S-corp and every one of its shareholders as related parties — regardless of how small the ownership stake is — and it ties the corporation’s accrued bonus deduction to the year the shareholder actually reports that bonus as income. For a shareholder-employee who is a cash-method taxpayer, that’s the year the money is actually or constructively received, not the year the board approved it or the books recorded it.
Any Shareholder Counts, Not Just Majority Owners
Most related-party rules in the tax code only bite above some ownership threshold. The individual-and-corporation rule in IRC Section 267(b)(2), for example, only applies once someone owns more than 50% of the company. The S-corp rule doesn’t work that way. Section 267(e)(1)(B)(ii) treats any person who owns, directly or indirectly, any stock of an S corporation as related to it — one share is enough. A 2% employee-shareholder, a family member who was gifted stock, or a founder with a controlling stake all land in the same bucket. There’s no safe harbor for a small enough ownership percentage, which is exactly what trips up S-corp owners who are used to thinking of “related party” rules as something that only applies to majority shareholders.
The Matching Rule Behind the Accrued Bonus Deduction
Under IRC Section 267(a)(2), a taxpayer can only deduct an accrued expense owed to a related party in the same tax year that the related party includes the payment in income. If the bonus isn’t includible in the shareholder’s income until paid — which is the normal rule for a cash-method individual — and the corporation and the shareholder are still related at the close of the corporation’s tax year, the deduction doesn’t disappear, but it shifts. It becomes allowable as of the day the shareholder includes the amount in income, “or, if later,” the day it would otherwise have been allowed. In practice: accrue a bonus on December 31 and pay it the following February, and the S-corp deducts it in the year it was paid, not the year it was accrued on the books.
Why the “2.5-Month Rule” Doesn’t Rescue a Shareholder Bonus
Plenty of owners have heard that an accrual-method business can deduct a bonus accrued at year-end as long as it’s paid within 2½ months — a rule that does exist for ordinary compensation accruals, under the deferred-compensation regulations at Treas. Reg. §1.404(b)-1T, which treat compensation received within 2½ months after the employer’s year-end as not deferred. That rule has no bearing on the Section 267 matching rule, and it does not create an exception for S-corp shareholders. Nothing in the current text of Section 267(a)(2) or 267(e) references a payment window; the only thing that matters is the tax year in which the shareholder includes the amount in income. A bonus paid to a shareholder six weeks into the next year is squarely inside the “2.5-month” window and still lands in the shareholder’s income — and the corporation’s deduction — in that next year, not the year it was accrued.
How Far the Rule Can Reach
The IRS and the courts have applied this rule aggressively. In Petersen v. Commissioner, 148 T.C. No. 22 (2017), aff’d 924 F.3d 1111 (10th Cir. 2019), the Tax Court held that participants in an S corporation’s employee stock ownership plan (ESOP) were related persons to the company under the trust-attribution rules in Section 267(c), because an ESOP is a trust and its participants are its beneficiaries. The Tenth Circuit affirmed. The practical result was that the company couldn’t deduct wages and vacation pay accrued for those participants until the year each participant actually received it — which, inside an ESOP, can be years after it was earned. The lesson isn’t that every S-corp has an ESOP problem; it’s that the related-party net catches indirect and constructive ownership too, not just a direct paycheck-to-paycheck relationship between the corporation and an obvious owner.
What Actually Works at Year-End
The fix is mechanical, not clever: if you want this year’s deduction for a shareholder’s bonus, the shareholder needs to actually or constructively receive the money before your tax year closes — not just have it approved, booked, or accrued on the balance sheet. Running bonus payroll before December 31, rather than approving a bonus in December for a January payroll run, is what keeps the deduction and the income inclusion in the same year. If cash flow means the bonus has to wait until next year, the cleaner approach is to plan for the deduction to land in that next year on the S-corp’s return, and make sure whoever prepares the shareholder’s Form 1040 and the corporation’s Form 1120-S are coordinating on the timing, since a mismatch between the two returns is one of the easier things for an examiner to spot.
Getting the Timing Right
None of this changes whether a bonus is deductible — it changes when. For a profitable S-corp trying to manage taxable income across two years, that timing difference is real money, and it’s easy to get wrong if you’re thinking about an accrued bonus deduction the same way you’d think about an accrued bonus to an unrelated employee or vendor. If you’re planning year-end compensation for yourself or other shareholders and want to make sure the deduction lands where you’re expecting it, reach out to our team before you run that last payroll of the year.