The Tax Effects of Paying Bonuses to Employees
Many employers may prefer paying bonuses to employees instead of giving raises. It's easier to give bonuses in one year and not the next, rather than to give pay raises that are built into the employee's base compensation. Bonuses are a great incentive for employees, but before you decide to hand them out, be sure you know the tax implications for your business and your employees.
How Bonuses Are Paid
It's always nice to give a bonus in a special check to make it stand out as important.
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 business 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. When you do something for employees once, they expect it the next time. When you do it twice, employees see it as an employment right and they start demanding it.
Bonuses are deductible to your business, in the tax 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. For example, you may want to give performance-related bonuses tied to evaluations. In this practice, as in others pertaining to employees, you must not discriminate against certain groups.
Bonuses to Business Owners
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. Basically, business owners can't give themselves bonuses.
Bonuses as Taxable Income to Employees
Employee bonuses are always taxable to employees as an employee benefit, no matter how or when they are paid. For example, a bonus paid to an employee at the time of hire (sometimes called a "signing bonus") is subject to all employment taxes. The employees must pay federal and state income taxes and FICA taxes (Social Security and Medicare) on bonus pay. You must also include bonus amounts in calculating unemployment taxes, the Social Security maximum, and the additional Medicare tax.
Withholding Taxes on Employee Bonuses
Bonuses may be considered supplemental wages, which are not included in regular pay. There are rules for calculating federal income tax withholding on employee bonuses, depending on how they are paid.
If you pay an employee a bonus combined with their regular wages, withhold federal income tax as if the total were a single payment for a regular payroll period.
If you pay the employee a bonus in a separate check from their regular pay, you can calculate the federal income tax withholding in one of two different ways:
- You can withhold a flat 22%.
- You can add the bonus to the employee's regular pay and withhold as if the total were a single payment.
If you aren't withholding taxes from the employee's paycheck (maybe because the employee claims an exemption from withholding), 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.
Bonuses and "White Collar" Employees
Bonuses can be discretionary (at the discretion of the employer) or non-discretionary for certain exempt employees. 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. A non-discretionary bonus is one in which the employer sets specific criteria for the bonus and employees expect the bonus if they meet the criteria. If you give an employee a performance bonus at the end end of a year one time, that's not discretionary. Holiday bonuses are considered discretionary. Another type of non-discretionary bonus is imposed by a contract, (a union contract or employment contract, for example).
Employees who are executives, administrators, professionals, and outside sales employees (sometimes called "white-collar employees") are exempt from federal minimum wage and overtime pay requirements, as long as their income is above a specific level. As of January 1, 2020, you can use non-discretionary bonuses to satisfy up to 10% of the standard salary level for employees, to bring them up to the minimum salary level to keep their exempt status.
You may not use discretionary bonuses to satisfy any portion of the standard salary level. These bonuses are ones in which you as the employer retain the discretion of the fact of the payment and the amount. 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.
These withholding procedures are complicated. See IRS Publication 15: Supplemental Wages, and check with your employment attorney for bonuses to exempt employees.
Changing Employee Withholding for Bonuses
If you decide to give your employees a bonus, you should 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 income taxes and FICA taxes on the bonus amount.