5 Things To Know About Year-End Bonuses

A detailed guide to planning your employees' bonus packages, tax considerations included.
President and Founder, Big Ideas for Small Business, Inc.
November 29, 2011

If your business has had a good year, decide how to share your good fortune with your staff. Year-end bonuses are a common way to do this.

When you give bonuses, it’s important to be fair. You want bonuses to promote continued company loyalty and motivate employees for outstanding future performance. You also need to adhere to tax rules on how to treat bonuses. Here are five practical points (including tax matters) to keep in mind.

1. You’re not alone

According to a survey by American Express OPEN, 29 percent of small-business owners plan to give bonuses to staff. While this is down from 54 percent in 2005, it is not an inconsequential percentage.

Ask your company’s financial adviser to help you review how much you can afford to dedicate to year-end bonuses.

Increasingly, businesses are giving performance-based bonuses. These payments are tied to workers achieving targets set earlier in the year. Some companies, however, still give bonuses regardless of performance, a percentage of annual compensation.

2. Bonuses subject to payroll taxes

Year-end bonuses are subject to the same payroll taxes as regular pay. This includes withholding for federal and state income taxes, as well as the employee share of FICA (Federal Insurance Contributions Act).

However, the federal income tax withholding on bonuses is figured at a flat rate of 25 percent. Some states may also have a special withholding rate for supplemental pay, including bonuses. Check with your state revenue department.

3. Deduction for bonuses depends on accounting method

If you report on a cash basis, a bonus check issued before the end of the year is deductible this year. This is so even if the recipient does not cash the check until next year.

For example, you may hand out a bonus check on December 30, 2011, the last workday of this year. The employee deposits the check on January 3, 2012. You can deduct the payment on your 2011 return.

If your business reports on an accrual basis, you can authorize bonuses this year that will be paid next year, yet get a tax deduction for them now. For example, on December 23, you announce a bonus for staff members. As long as the checks are paid to employees by March 15, 2012, you can deduct the accrued bonuses on your 2011 return.

Note of caution: Bonuses given to employees of C corporations owning more than 50 percent of the stock or to employees of S corporations owning any percentage of stock are not deductible until the checks are actually paid.

4. Bonuses to a group of employees

What happens if you determine before the end of the year that a group of employees, such as your sales staff, will receive a certain collective amount, but you don’t set the amount for each salesperson until next year? The IRS says that you can accrue the total bonus amount this year, allowing you time to parse out individual bonuses after the new year.

5. Employee deferral of bonus payments

You may wish to give employees (and yourself, if you’re an employee of your corporation) the choice of receiving bonuses now or deferring receipt until some future date, such as retirement. Deferring receipt transforms the bonuses into deferred compensation, for which special restrictions apply.

Opting for deferral is premised on the notion that tax rates for the recipient will be lower in the future. There is no way to know for sure what future tax rules and rates will be. But deferral can be helpful as forced savings for the future and can ensure a more financially sound retirement.

NoteFICA taxes apply to bonus payments now, even though receipt of the funds is deferred until the future. There is no more FICA when the deferred compensation is received later.

Final word

Whatever you decide about bonus payments, be sure to add personal thanks when you hand them out.

Looking ahead, you may wish to start now crafting a performance-based bonus plan for next year, so your staff can start the new year off right.

Barbara Weltman is an attorney and prolific author with such titles asJ.K. Lasser’s Small Business Taxes and The Complete Idiot’s Guide to Starting a Home-Based Business. She is a trusted professional advocate for small businesses and entrepreneurs. She publishes Idea of the Day® and monthly e-newsletter Big Ideas for Small Business® and hosts Build Your Business radio. Follow her on Twitter @BarbaraWeltman.

President and Founder, Big Ideas for Small Business, Inc.