Many employers start thinking about gifts or bonuses for employees during the holidays, at the employee's work anniversary, or at an achievement recognition ceremony. But before you give out those awards or bonuses or gifts, consider the tax implications for your business and for the employees.
Two Questions to Ask First
Are These Gifts/Awards/Bonuses Taxable to the Employees?
If they are taxable income to the employee, you must withhold federal, state, and local income taxes and deduct the employee's share of FICA taxes (Social Security and Medicare taxes). You must also pay unemployment tax on these amounts.
Are These Gifts/Awards/Bonuses Deductible to Your Business?
Most of these payments are deductible as "ordinary and necessary" business expenses. These expenses must also be reasonable and they must be for "services performed." Some deductions have limits and qualifications.
Gifts to Employees and De Minimis Payments
Most gifts to employees are taxable to them, but some small gifts are considered de minimis, and these aren't taxable.
These payments are called de minimis because they are small cost and infrequent, "so small as to make accounting for it unreasonable and impractical." De minimis items include holiday gifts, occasional tickets for entertainment events, flowers, fruit, or books, etc., under "special circumstances."
Cash payments or cash equivalent cards you give to employees are considered to be wages and these are always taxable to the employee. Gift certificates that can be redeemed by the employee for retail products also aren't de minimis and they are taxable to the employee.
Bonuses to Owners and Employees
Bonuses for employers/owners are a business expense and your business can deduct them under certain circumstances.
How and when you pay bonuses to business owners depends on the type of business.
- S corporations can deduct bonuses for shareholders and owners, as long as they own their shares at the time the bonus is paid.
- Corporations can deduct bonuses for corporate officers who are paid employees.
- Bonuses are not deductible for small business owners (sole proprietors, partners, and LLC owners) because the owners are considered by the IRS to be self-employed. The money these business owners pay themselves is considered a draw or distributive share, not a bonus.
Bonuses to employees are considered income and they are always taxable to the employee.
If you decide to give your employees a bonus, you should allow them to change their withholding (on Form W-4) for that paycheck, and change it back again for later paychecks. Many employees like to change their bonus check withholding to get more of the bonus. (See details below.)
Bonuses are considered additional pay for services and are deductible business expenses as long as they are a reasonable amount and they are tied to services by the employee. The bonuses can't be a gift.
Employee Awards and Business Tax Deductions
Taxable to Employees
Service and safety awards are not taxable to employees if they are limited. There are limits on service awards (not during the first five years, and not more often than every five years) and safety awards (not to more than 10% of employees). Awards over the limits are taxable to the employee.
Deductible to Your Business
You can deduct the cost of employee awards from your business taxes, for both cash or personal property (like a watch). This includes achievement, service, and safety awards. There are requirements and limits for deducting each of these types of awards.
See IRS Publication 535 Business Expenses for details on these requirements and limits.
Your business may take higher deductions on awards given as part of a qualified plan that fits IRS requirements. A qualified plan is a specific written plan or program that doesn't favor highly compensated employees. Highly compensated employees are those that are either a 5% owner or who received more than a specific amount, as defined by the IRS each year.
Supplemental Wages and Withholding
The IRS considers bonuses, gifts, and rewards in the category of supplemental wages. How you withhold from employees on supplemental wages depends on whether the payment is separate from regular wages (like a separate bonus check).
This withholding is for federal income tax only. In general, if the wages are paid in a regular paycheck, withholding is done on the whole paycheck in the normal way, including the supplemental part. If you pay the supplemental wages in a separate check, you can withhold a flat 22% or you can withhold at the normal rate you are currently using for that employee. (This is an oversimplification and there are many exceptions.) Please check IRS Publication 15 for more details.
Withholding and "Grossing Up" Employee Cash Gifts or Bonuses
Employee gifts are usually small enough that you don't need to worry about employees wanting to change their withholding allowances. But for larger bonuses, you should give employees the option of changing their W-4 withholding deduction amount for that one paycheck.
You must allow employees to change their W-4 forms as often as they wish. This process requires two W-4 forms – one for the withholding on the bonus check and another to return to the employee's original withholding amount.
For example, if you give an employee a $1,000 bonus, by the time you take out taxes, the bonus check might be only $750. You can calculate a higher amount for the bonus so that the check shows the full $1,000. The employee is getting what looks like a higher bonus, but the amount is after taxes. Paycheckcity has a gross-up calculator you can use to help determine the net amount of a bonus check, allowing for payroll taxes.
Disclaimer: The information in this article and on this site is for general information purposes only. These tax issues are complicated, and every situation is different, so you should consult your tax advisor before you do anything that could have a tax effect.