Are You Giving Your Employees Bonuses? Check Out the Tax Implications
Last revised: February 8, 2018
Year-end bonuses are a great way to reward your employees’ hard work.
If you’re considering giving out year-end bonuses, ask yourself why. Did your company do really well this year and you want to share the wealth through holiday bonuses? Did your employees perform exceptionally well and you want to give them a performance-based bonus? Whatever your reason for giving out year-end bonuses, be transparent and share that reason with your employees.
When you’re announcing the bonuses, make sure to phrase them as a one-time thing. Otherwise, your employees might begin to expect a bonus every year.
Before you start writing those checks, make sure you know the tax implications.
Discretionary vs. Non-Discretionary Bonuses
There are two different types of bonuses: discretionary and non-discretionary.
Discretionary bonuses are not expected by your employees. For example, a performance-based bonus would be discretionary if you don’t give them out every year – only in years when an employee goes above and beyond. The only exception here is holiday bonuses. A holiday bonus is always discretionary, even if you hand them out every year.
Non-discretionary bonuses are expected by your employees or imposed on you by a union contract or employment contract. Non-discretionary bonuses include sales bonuses and signing bonuses. You must add non-discretionary bonuses to your employees’ weekly gross pay when determining overtime pay for hourly and non-exempt employees.
How are Bonuses Taxed?
The IRS considers bonuses “supplemental pay,” so they’re treated like any other pay to your employees. They’re subject to income tax withholding, FICA taxes, and FUTA taxes. When you’re considering whether you can afford to hand out holiday bonuses, make sure you factor in your employment tax obligations.
You can withhold a flat amount of income tax. The flat rate is 25%. Although not likely for small businesses, if you’re writing a bonus check for over $1 million dollars, the flat rate is a bit higher (39.6%).
You can combine your employee’s regular pay and their bonus amount to determine their income tax withholding, but take the additional tax only out of the bonus check.
Don’t forget that if this bonus puts an employee’s pay over $200,000 for the year, you’ll have to withhold an additional 0.9% Medicare tax on any taxable amount over $200,000. You should also remember the social security wage base. Social security taxes are withheld from the first $128,400 an employee makes each year. Keep that in mind, if an employee reaches that amount with their holiday bonus.
Don’t forget to report the bonuses and payroll taxes on your Form 941.
If you report on a cash basis, then you deduct the bonuses from the tax year you paid them. So, if you pay the bonuses by December 31, 2017, you can deduct them from your 2017 income.
If you report on an accrual basis, you have a little more flexibility.
If you declare the bonuses and put them in writing before the end of the year, then you have until March 15 of the following year to pay them out. As long as you declare the bonuses in writing by December 31, 2017, you have until March 15, 2018 to pay out the bonuses.
This only applies to rank-and-file employees. C Corporation owner-employees (who own 50% or more of the company) and S Corporation owner-employees (who have any ownership interest) can only deduct their bonuses at the time the bonuses are actually paid.
If you report on an accrual basis, you can also set up a bonus pool. You can budget a fixed amount for bonuses, then allocate the funds based on your preferred measurement, such as performance.
As long as the pool amount is fixed and determinable, you can deduct these bonuses from your income. You must set the amount by December 31.
If you change the pool in anyway after December 31, then you cannot deduct it for that tax year. For example, you cannot deduct the bonuses if
you retain the right to modify or eliminate the bonuses at any time prior to payment;
the Board of Directors retains the right to modify or eliminate the bonuses at any time prior to payment;