Any employer can offer a special incentive for their employees as an end-of-year bonus, gift, prize, or award. Now, more than ever, employees are looking forward to some form of incentive to help cover holiday costs and so on. If you own a company, and you’re thinking about offering employee bonuses, there are a few things you should know. In this article, we will outline key points to consider.
As a business owner, once you’re offering cash bonuses it is still classified as wages that will be subject to FITW, FICA, FUTA, and other applicable state and local payroll taxes. The Internal Revenue Service (IRS) considers these cash gifts or bonuses as supplemental wages, which are subject to payroll tax. If given after FIT was withheld from regular wages—or with regular wages but identified as separate—you can use the 25% supplemental withholding rate. If wages exceed $1 million for the year, withhold at 39.6%.
There are two different types of bonuses that employers can issue to their staff this Christmas season 2021; Discretionary (lump-sum) bonus and Nondiscretionary bonus.
Discretionary Bonus
This is a lump-sum bonus that is excludable from overtime calculations. In order for it to be considered as discretionary, it must be the employer’s decision on how much to give. In other words, as the name suggests, the amount issued to the staff is up to the employer’s discretion.
Typically, a discretionary bonus cannot be required by a contract, agreement, or promise. Additionally, it cannot be given in a pattern so that it is expected. So, this bonus must be a complete surprise to the employee.
A holiday bonus, however, can be discretionary even if it is an expected gift each year. This means that a Christmas bonus would be classified as discretionary.
Nondiscretionary Bonus
A Nondiscretionary Bonus is any incentive that is required under a contract, agreement or promise. This is applicable whether this was expressed or implied in the agreement or not. So, any incentive to boost productivity or to attract or retain an employee would be classified as nondiscretionary. Additionally, any bonus that employees would have come to expect are classified as nondiscretionary.
For employees that are paid hourly wages, nondiscretionary bonuses must be added to weekly gross pay for the week in which they are earned. They must also be included when computing the week’s overtime.
N.B:
Employees who elected to contribute salary to a flexible spending account (FSA), with or without COVID amendments, should be reminded that to use the year-end account balance so that leftover money does not revert to the employer, they must incur enough qualified medical expenses by Dec. 31, 2021.
If your company’s plan allows for it, tell employees they have until Mar. 31, 2022, to submit receipts and claim reimbursement using 2021 FSA contributions for expenses incurred through Dec. 31, 2021.
Signing and Related Bonuses
A bonus given for signing or canceling an employment contract is wages subject to FIT, FITW, FICA and FUTA.
Cash Prizes and Awards
Include in wages the fair market value (FMV)— not the cost—of prizes and awards and apply all taxes. Also include the FMV of prizes/awards for production, attendance, efficiency, or other on-the job achievements in that employee’s straight-time pay to compute the O.T. premium.
Length-of-service or safety awards [IRC §3121 (a) (20)]
Long-service or safety awards can be excluded from federal taxable wages—if they:
- are not “disguised compensation”;
- are given under a written qualified plan or program that does not favor highly compensated employees;
- do not exceed an average of $400 per employee (or $1,600 for the year) and, if not paid under a qualified plan, do not exceed $400 per employee;
- are not tangible personal property, cash or cash equivalents, such as stocks, bonds, meals, lodging, or tickets for sports or theater; and
- are given in some kind of ceremony. [IRC §74(c), 274(j)]
Length-of-service awards are federal taxable wages if given before 5 years’ service but non-taxable after 5 years’ service and not given more frequently than every 5 years.
Safety awards are excluded from federal taxable wages if also given to management, administrative, professional, clerical, and part-time employees but not to more than 10% of eligible employees during the taxable year. If, say, 12% of employees qualify, all safety awards are taxable for all employees.
Suggestion awards are excluded from an employee’s hourly pay rate when calculating overtime pay—if :
- the employee was not required to give suggestions;
- the award was not geared to the person’s salary;
- no time limit was set for submitting suggestions;
- offering suggestions is not part of that job (e.g., if the job is not troubleshooting equipment and the suggestion applies to equipment, or in response to a survey of employees asking for ideas on how to improve some procedure);
- the employee made a suggestion completely on his or her own (no employer input at all);
- the employer had no idea that the employee was working on the suggestion.
Noncash prizes
Include the FMV in wages subject to FIT, FITW, FICA, and FUTA. [Rev. Rul. 57-18, CB 1957-1, 35] Nontaxable gifts. Fruit baskets, hams, turkeys, wine, flowers, and entertainment tickets to a show, sporting or other event (but not season tickets)
How the IRS Taxes Employers
From the employer’s perspective, bonuses are taxed the same way as regular compensation.
For 2021, employer payroll taxes include a matching 6.2 percent on the first $142,800 of earnings for Social Security tax and 1.45 percent of earnings (with no cap) for Medicare tax.
Again, your tax professional or full-service payroll provider can assist with paying the correct employer payroll taxes on any employee bonuses.
Deducting Employee Bonus Pay as a Business Expense
Businesses can generally claim a tax deduction for the salary, wages, commissions, bonuses, and other compensation paid to employees. However, the year you claim a deduction for employee bonuses depends on whether you use the cash or accrual method when filing your tax return.
If you use the cash method, you can deduct bonus payments and other employee compensation in the year they’re actually paid to the employees. In other words, you must have paid the bonus before the end of the tax year to claim a deduction on that year’s tax return.
If you use the accrual method for tax purposes, you may be able to deduct accrued bonuses. Accrued bonuses are ones you’ve agreed to pay but don’t actually pay out until the next year. To be deductible, the bonus amount must:
- Have been determined by the end of the year
- Be paid to a non-related employee
- Be paid to the employee within 2½ months of year-end (March 15 for a calendar-year company)
Bonuses Paid to Business Owners
If your business is a sole proprietorship, partnership, or LLC, you won’t be able to deduct bonuses paid to yourself or your business partners. This is due to the fact that IRS considers sole proprietors, partners, and LLC members as self-employed.
Only businesses that file taxes are eligible for bonus deductions. This includes S corporations, C corporations, and LLCs that have elected to be taxed as a corporation.
The Bonus Tax Rate: Don’t Be Confused
It is not a secret that offering bonuses is a great way to show you appreciate to your employees for their hard work, loyalty, and dedication to your company. So, if you really want to reward your staff for their performance or impact, be sure to work with your payroll provider to understand bonus tax rates and how they apply to your business. They should also be able to help you to calculate withholdings and payout employee bonuses correctly.
Year-End Reminders
Remind employees about FSA year-end. Employees who elected to contribute salary to a flexible spending account (FSA), with or without COVID amendments, should be reminded that to use the year-end account balance so that leftover money does not revert to the employer, they must incur enough qualified medical expenses by Dec. 31, 2021.
If your company’s plan allows for it, tell employees they have until Mar. 31, 2022, to submit receipts and claim reimbursement using 2021 FSA contributions for expenses incurred through Dec. 31, 2021.
There are two other exceptions to the year-end use-it-or-lose-it rule. Your company’s plan may have either one—but not both.
The March 15 grace period. Expenses incurred between Jan. 1-Mar.15, 2022, can be applied against 2021 FSA contributions until the balance is exhausted. Expenses incurred through Mar. 15, 2022, cannot be applied against 2022 contributions until the 2021 contributions are exhausted.