Paying Bonuses to Employees - Tax Effects

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Many employers are paying bonuses to employees instead of giving raises, according to the Washington Post. Bonuses are easier to stop than a continuing pay raises, and they have an immediate positive effect on employees. 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.

How Bonuses are Paid

Just to be clear, a bonus is a special one-time or annual payment to an employee for some special purpose. The bonus is an additional payment beyond the salary or hourly rate of pay for the year. You can decide who receives a bonus, the amount of a bonus, and when it is paid. You can put a bonus into an employee's regular paycheck, but it's usually good to give a separate check, for extra effect.

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. 

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. For example:

  • 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 that 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 overtime purposes 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. The Department of Labor has more information on how to calculate bonuses and overtime.

Calculating Bonus Amounts for Employee Taxes

Bonuses are considered supplemental wages to the employee. When you figure taxes for bonuses, there are two ways to do this for employees who have taxes withheld from their paychecks:

As part of the employee's regular pay. In this case, you just add the amount to the paycheck and include the bonus amount in your calculations of federal and state income tax withholding and FICA taxes for both the employee and employer.

As a separate check, using a supplemental rate. You can calculate the income taxes on this amount using 22 percent. You also must withhold FICA taxes at the usual rate, and any state income taxes, from this check.

If you aren't withholding taxes from the employee's paycheck (maybe because the employee is exempt), you must add the bonus amount to the employee's current paycheck and figure the withholding as if the regular paycheck and the bonus amount are one amount.

Depending on the employee's tax rate, either of these methods might result in lower or higher taxes. Don't be surprised if employees ask you to figure their bonus both ways to see which results in more withholding.

These withholding procedures are complicated. See IRS Publication 15: Supplemental Wages for more details or check with your payroll service.

No matter how you calculate the bonus for employee taxes, you must

  • Pay the employer part of FICA taxes on bonus amounts, and
  • Report the bonus along with other payments to employees on Form 941, the quarterly wage and tax report. 

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; this is called "grossing up" the check. They still must pay tax on the bonus; it's a matter of perception.