Tax Implications of Bonuses

If your business rewards your team's performance with bonuses, there are tax implications to understand.

You can generally deduct the cost of bonuses as compensation for services. If you use cash-method accounting, remember that you can only deduct bonuses paid by the end of the tax year to have them deductible that year. Accrual-method businesses benefit from the rule that generally lets them deduct a bonus for performance accrued during the year but not paid, as long as it is paid within two-and-a-half months after year end. No deduction is allowed for accrued bonuses to related parties, which includes but is not limited to shareholders owning more than 50 percent of the outstanding stock of a corporation and related family members.

In order for bonuses to be deductible, the amount of bonuses to be paid must be determined with reasonable accuracy before the end of the year in which the deduction is taken. If the exact amount is not known before the end of the year, the formula for determining the amount must be established before the end of the tax year. The formula must be fixed and not subject to optional payments. Requiring that eligible employees are still employed on the date the bonus is paid will preclude the liability from being fixed at the end of the year and cause the bonuses to instead be deducted in the year they are paid.

Payroll considerations

Bonuses are considered supplemental wages. (Other forms of supplemental wages are commissions, overtime compensation, severance pay, awards and prizes, back pay, tips, payments for nondeductible moving expenses, retroactive raises, and payments for accumulated sick leave.) That means you will withhold the usual FICA and federal unemployment tax as well as any applicable state taxes, and be subject to employer payroll taxes. If you're concerned about common misconceptions regarding payroll, check out our blog on Payroll Myths Exploded to ensure your business stays on the right track. The federal income tax withholding amount depends on the total amount of supplemental wages received by the employee during the tax year. If the supplemental wage payment is more than $1 million, the first million gets withheld at 22 percent and every dollar over that is withheld at 37 percent or the highest income tax rate for the year.

For supplemental wages of $1 million or less, you can choose one of the following methods for calculating federal withholding tax:

• If you pay supplemental wages with regular pay without specifying the amount of each, withhold federal income tax as if the total were a single payment for a regular payroll period.
• If you pay supplemental wages separately, or combine them in a single payment with wages and specify the amount of each, you can:
  • Withhold a flat 22 percent of the bonus.
  • Use the aggregate method—an IRS formula based on the employee's tax bracket (as given on their W-4)—to calculate the amount to withhold. This is a more complicated way to calculate withholding but may better ensure that you cover the employee's tax liability.

A bonus is always a welcome bump in pay. If you need guidance about how bonus payments affect company and employee taxes in your business, contact your R&A advisor.