Has 2016 been a good year for your business? The time is growing short for you to address the matter of year-end bonuses.
According to the 2016 Holiday Bonus and Hiring Survey by Accounting Principals, 75% of HR and hiring managers of the companies polled are planning to give bonuses this year (up from 67% last year). The average amount is over $1,000 per employee.
While this survey obviously addresses bonuses for larger firms, small businesses may want to take note. Whether you give the average or some other amount, here are some things to consider.
Determine your budget for bonuses
Employers are under no legal requirement to pay year-end bonuses, but many do as a way to reward employees for their good work. Factors to consider in setting bonuses:
- How good a year you had. The better your revenue, the more you have to spend on employees. Of course, you may opt instead to increase contributions to their retirement accounts, which would be deductible by the company while tax-deferred to employees.
- What you paid last year. Employees remember what they received before and may feel slighted if they get less this year. Refer to last year’s bonus amounts so you can match or exceed the amount last year if fiscally possible.
- What you think is being paid by competitors. The amount of bonuses varies with the type of industry you’re in. Paying a competitive bonus amount is a way to retain your workers.
Don’t forget to factor in payroll taxes, as explained next.
Factor in payroll taxes
Because bonuses are taxable compensation to your employees, there’s an added cost to the company for employment taxes. Bonuses, like other compensation, are subject to income tax withholding (a cost to employees), as well as FICA taxes (a cost to both employees and the company) and FUTA tax (a cost to the company).
For purposes of federal income tax withholding you have a choice for how to treat this “supplemental pay”:
- Consider the bonuses as part of regular compensation. Then figure withholding using standard withholding tables. You can take the additional taxes only from the bonus check (see IRS Circular E).
- Withholding a flat amount of income tax on the bonus. Usually the rate is 25%, but large firms paying bonuses in excess of $1 million use a flat rate of 39.6%.
Check state income tax rules for withholding at the state level (and local level where applicable).
Note that an employee may opt to have additional taxes withheld for federal income tax purposes. This may occur where the employee knows he/she is in a tax bracket higher than the 25% rate you’ve withhold is you’re using the flat rate.
Decide when to pay the bonuses
Bonuses typically are distributed around holiday time. Some companies do this sooner rather than later so employees have cash for their holiday shopping and travel needs.
Accrual-basis businesses have leeway in paying out bonuses, which can be helpful if holiday sales may be needed for this cash flow. They can declare bonuses before the end of the year and deduct them for 2016 as long as they are paid within 2½ months after the end of the year. However, bonuses paid to employees of S corporations with any ownership interest are deductible only when actually paid. Similarly, the deductible-when-paid rule applies to owner-employees of C corporations with a more-than-50% ownership interest.
Accrual-basis businesses that need time after their busy holiday season to decide how much each employee is entitled to from a bonus pool and claim the deduction this year if they follow IRS guidance. For example, an employee must still be employed when his/her share of the bonus pool is actually paid out.
Some employees, such as owners and upper management, may want to defer the receipt of year-end-bonuses to a future date, such as retirement (when they expect their income to be lower). In order for employees to avoid current income tax on year-end bonuses, the deferred compensation arrangement must meet certain criteria. The IRS posted frequently asked questions on deferred compensation to guide you. Of course, with the prospect of lower income tax rates under a new administration, deferral may not be as attractive as it has been up to now.
Don’t know what to pay? Consult with your financial advisor now so you can make arrangements for year-end bonuses before it’s too late.