It’s that time of the year again and bonuses are on everyone’s mind. Your employees want it, but how much and whether they actually get it is up to you as the employer. Let’s have a look at some of the most important aspects to consider when planning your end of year bonuses.

What exactly is a “bonus”?

A bonus is a form of compensation that is usually paid at the end of the financial year. It isn’t guaranteed, and payment is at the discretion of the employer.

In today’s competitive job market, bonuses have evolved beyond mere year-end rewards. Many companies are now offering performance-based bonuses throughout the year to incentivize employees and align their efforts with business goals. This approach not only motivates employees but also helps retain top talent in a dynamic employment landscape.

Does the government consider bonuses as wages?

The government still considers these wages. However, bonuses may be categorized as supplemental wages. They are similar to vacation pay, commissions, overtime and severance pay.

It’s important to note that the classification of bonuses as supplemental wages can have implications for how they are taxed, not just at the federal level but also at the state level. Employers should stay informed about the varying tax treatments across different jurisdictions to ensure compliance and optimize tax efficiency.

How are bonuses taxed?

Bonuses, or supplemental wages, can be taxed in two ways.  The main difference being the amount of tax withheld. They can either be taxed in combination with regular wages using the Aggregate Method or separately using the Percentage Method.

Aggregate Method

When using this method, Employees will often calculate taxes on the lump sum of both regular wages and the bonus. This method usually results in an increased amount of taxes being withheld from the employee’s paycheck, as it moves the employee into a higher tax bracket.

With rising inflation and economic pressures, employees are more sensitive to the amount of take-home pay they receive. Employers might consider explaining the implications of the Aggregate Method to employees upfront or exploring alternatives that can mitigate the impact of higher tax withholding.

This method isn’t usually a favorite under employees and to address this the IRS allows employers to declare bonuses using another method, called the Percentage Method.

Percentage Method

This method is pretty straight forward, but not everyone is aware of it. Using this method, especially for higher-income earners, your Payroll Service Provider will withhold federal income taxes on the bonus at a flat rate of 22%. This means a predictable amount of taxes are withheld and keeps taxes lower and employees happier.

Given recent changes in tax legislation, it’s crucial to stay updated on the current flat tax rate for bonuses. Employers should also consider whether state and local taxes might affect the net amount employees receive, and communicate these details clearly to avoid surprises.

Non-taxable Bonuses

Unfortunately, all monetary bonuses need to be taxed. However, gifts of the non-monetary type can be exempted. Are you planning to reward employees with gift baskets of food for the holidays? These are considered “de minimus” and may be exempt from being declared on an employee’s income tax form.  Just keep in mind that any gift certificate or card that can be converted to cash or cash equivalent is not considered “de minimus”.

The IRS has specific thresholds for what qualifies as “de minimis” benefits. It’s a good idea to stay informed about these limits and ensure that any non-monetary gifts you provide fall within the allowable range to avoid any tax complications for your employees.

Benefits of Paying Bonuses

Employers may find that paying bonuses could hold some major benefits. Bonuses aren’t only great for boosting morale and ensuring great work performance for the coming year, there are also some business tax-related benefits that your Payroll Service Provider could advise you on.

Beyond morale, bonuses can play a critical role in fostering employee loyalty and reducing turnover, especially in industries where competition for talent is fierce. Additionally, with the rise of remote work, offering bonuses tied to specific performance metrics can help maintain productivity and engagement across dispersed teams.

Employee Benefits Tax Deduction

Bonuses are considered Employee Benefits, and as such employers can take a tax deduction on their business tax return for the cost of providing these benefits. It is considered a necessary business expense.

Employee Benefits as deductible business expenses fall under the “payments to employees” category.

How to Include Employee Benefits Expenses

Depending on the type of business you have, you will deduct employee benefits differently on your return form:

• Sole proprietors /Single-member LLCs: “Expenses” section of Schedule C
• Partnerships / Multiple-member LLCs: “Deductions” section of Form 1065
• Corporations: “Deductions” section of Form 1120

With recent updates in tax regulations, it’s more important than ever to ensure that employee benefits, including bonuses, are correctly categorized and deducted. Consulting with a tax professional or payroll expert can help you navigate any changes and optimize your deductions.

For more information, and assistance with your payroll and tax compliance, feel free to contact us for personal advice from our team of experienced accountants. Your payroll will be processed on time, accurately and always in accordance with federal and state tax requirements ensuring more benefits to you and your employees.