When you pay employees bonuses, there are several tax and legal obligations you should be aware of.
Bonuses and Overtime Pay
One of the most common mistakes that employers make is not realizing that some bonuses affect overtime pay. You may have to pay overtime based on an employee’s effective pay rate with the bonus rather than his base pay rate.
Discretionary bonuses do not have to be calculated into overtime pay. Non-discretionary bonuses do.
A discretionary bonus is a bonus where the employer has the sole discretion to determine whether a bonus is given and the amount. There generally can’t be any agreement with or promise to the employee.
A non-discretionary bonus is a bonus promised to an employee if certain conditions are met. Common examples include:
- Meeting sales targets or production goals
- Attendance bonuses
- Performance bonuses
- Other bonuses based on predetermined criteria
Caution: If you base employee bonuses based on set criteria, such as sales, but did not make a promise in advance, don’t automatically assume it’s a discretionary bonus. Talk to an employment law attorney or tax accountant first.
Discretionary Bonus Example
Employee makes $20 per hour and works 60 hours in a week. You give a $1,000 holiday bonus that was purely discretionary.
- Base pay: $20 x 40 = $800
- Overtime pay $20 x 1.5 = $30 x 20 = $600
- Bonus = $1,000
- Total pay = $2,400
Non-Discretionary Bonus Example
Employee makes $20 per hour and works 60 hours in a week. You give a $120 bonus based on sales targets.
Because the bonus is non-discretionary, you need to convert the bonus into hourly pay. $120/60 = $2.
- Base pay: $22 x 40 = $880
- Overtime pay: $22 x 1.5 = $33 x 20 = $660
- Total pay: $1,540
Note: When a bonus covers multiple pay periods with varying hours, the math can get a little complicated. Contact a tax accountant or make sure your payroll provider is properly set up to handle this situation.
Withholding and Payroll Taxes
Bonuses are subject to income tax withholding and payroll taxes just like any other compensation.
In most cases, bonuses are subject to the same FICA (Social Security and Medicare) and unemployment taxes as salaries or hourly wages. For highly compensated employees, bonuses aren’t subject to Social Security tax once the employee’s total compensation has reached the wage base for the year.
There are two methods for calculating income tax withholding on bonuses. (At least for the IRS. State rules may vary.)
Flat Rate or Percentage Method
If you pay bonuses in a separate paycheck:
- Withhold a flat 22% for amounts up to $1 million
- Withhold 37% for amounts over $1 million
If you include the bonus in a regular paycheck, calculate payroll taxes as usual as if the bonus was part of regular pay.
For large bonuses, employees may have taxes withheld as if they’re in a larger tax bracket due to the high paycheck. Employees will get a refund based on their actual tax brackets when they file their tax returns.
Other Rules to Be Aware Of
There are a few other employer bonus responsibilities you should be aware of.
Executives and Shareholders
If you pay bonuses to executives or shareholders, special rules apply.
- There may be limits on your ability to deduct the bonus based on how the bonus is structured and who is eligible for it.
- Bonuses may be deductible when the conditions for the bonus are met rather than when you paid the bonus.
Stock Options and Equity
If you give any kind of equity or stock option, talk to your accountant before you even discuss the compensation package. The rules can get complicated.
- Tax to the employee may be based on when the option was granted, when it vests, or when it’s exercised.
- Similarly, when the employer can take the deduction may vary.
- Employer deductions for options granted to highly-compensated employees may be limited.
Answering Common Employee Concerns
When employees receive bonuses, it’s common for them to be worried that their take-home pay will be lower due to taxes. In most cases, this is not true.
First, taxes work on a marginal tax rate system. If you move from the 22% bracket to the 24% bracket, you don’t pay 24% on all of your income. You only pay 24% on the amount in the 24% bracket and still pay the lower tax rates for the lower brackets.
Second, even if your bonus gets taxed high, withholding on bonuses is only an estimate. When you file your tax return, you’ll get a refund if you got taxed too high.
Finally, there are some situations where a bonus can cost employees money. This is usually when the bonus puts the employee over the income limit for tax deductions, tax credits, or government assistance.
- Affordable Care Act health insurance subsidies
- Earned Income Tax Credit
- Education tax credits
- Other tax deductions like IRA contributions
- Food stamps
- Income restricted housing
So never tell employees that bonuses won’t increase their taxes. If they have concerns beyond tax rates, they may be valid.
Have them discuss their situations with a tax accountant and consider whether you want to adjust their compensation accordingly.