Giving Employee Bonuses? Know the Tax Implications
Employee bonuses are a great incentive for employees, but before you decide to hand them out, be sure you know the tax implications first - to your business and your employees.
Bonuses may be contractual, such as sales bonuses for salespeople, or they may be for performance awards.
Another type of bonus is a special holiday bonus to a group of employees who have met a specific sales or production goal or for overall yearly profitability.
Bonuses are typically paid out in a special check.
Deducting Employee Bonuses as a Business Expense
If you have some cash and expect to make a profit this year, it's a good time to pay bonuses to employees. In addition to receiving a tax deduction for these benefit expenses, you also receive much goodwill from employees, especially around the holidays.
Announce the bonus as a one-time event, so you don't give the expectation that you will be giving out bonuses each year. It's funny how when you do something once; people come to expect it. When you do it twice, people see it as an employment right, not just a privilege.
Bonuses are a deductible business expense, in the category of "payments to employees." If you give bonuses to some employees and not others, make sure you have a clear rationale for this difference.
You may want to give performance-related bonuses, tied to evaluations, for example. Susan Heathfield, Human Resources Expert, has an excellent article on giving bonuses to employees, to help you carefully consider this process.
Bonuses to Employee/Owners
Employee/owner bonuses are a legitimate business expense and can be deducted under certain circumstances.
- S Corporations can deduct bonuses for shareholders and owners, as long as they own their shares at the time the bonus is paid.
- C Corporations can only deduct bonuses for shareholders/owners who have a 50 percent or higher ownership at the time the bonus is paid.
Bonuses are not considered deductible expenses for sole proprietorships, partnerships, and limited liability companies (LLCs) because the owners/partners/members are considered by the IRS to be self-employed. It is one situation in which having a corporation and being an employee of that corporation might result in more tax deductions.
Bonuses as Taxable Income to Employees
Employee bonuses are always taxable to employees as an employee benefit. You must withhold federal and state income taxes and FICA taxes (Social Security and Medicare). You must also include bonus amounts in calculating unemployment taxes, the Social Security maximum, and the additional Medicare tax.
Bonuses and Overtime
Bonuses can be discretionary (at the discretion of the employer) or non-discretionary. It's important to know the difference, because non-discretionary bonuses may need to be included in overtime pay calculations.
A bonus is discretionary if it's not expected.
If you give an employee a performance bonus at the end end of a year, and you don't give it every year, that's discretionary. The only exception is that the IRS says that holiday bonuses can be discretionary, even if they are given every year.
Non-discretionary bonuses are those imposed on the employer, by a union contract, employment contract, or as a bonus employees expect (except for the holiday bonus noted above). Signing bonus (for signing a contract) are non-discretionary.
Non-discretionary bonuses must be added to weekly gross pay for hourly employees and for exempt employees who are eligible for overtime. For example, let's say an employee's pay for the week, including the non-discretionary bonus, is $650, and the employee worked 3 hours of overtime. The employee's regular rate of pay is $15.11.
The overtime premium is 50% or $7.56 per hour. The total overtime premium for the 3 overtime hours is $22.67, which is added to the regular pay for a total of $672.67.
Calculating Bonus Amounts
When you calculate the amount of the bonus, you must treat the check as a regular paycheck:
- You must withhold federal and state income taxes from the bonus check
- You must calculate and withhold FICA taxes (Social Security and Medicare) from the employee paycheck, and
- You must pay your part of the FICA tax as the employer.
- You must also report the bonus along with other payments to employees on Form 941.
Changing Employee Withholding for Bonuses
If you decide to give your employees a bonus in December, or anytime, you must give them the opportunity to change their withholding authorization (on Form W-4) for that paycheck, and change it back for subsequent paychecks. Many employees like to change their bonus check withholding, so they receive more of the bonus.