It’s been reported that about 66% of all businesses plan to give year-end bonuses in 2020. But is this true for small businesses? Many have closed; others are hanging on by a thread. Still, some small businesses have done well in 2020. Owners may want to share their good fortune with those who made it possible…valued employees.
Have you factored in payroll costs?
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 wages”:
- Consider the bonuses as part of regular compensation if they are paid concurrently. Then figure withholding using standard withholding procedures. 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. The rate is 22% (although large firms paying bonuses in excess of $1 million use a flat rate of 37%).
Remember that once an employee’s compensation tops $200,000, you must withhold an additional 0.9% to cover the employee’s extra Medicare tax on earned income. There’s no employer matching of this amount.
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 22% rate you’ve withhold if you’re using the flat rate.
Have you considered deferral?
Some employees, such as owners and upper management, may want to defer the receipt of year-end-bonuses to a future date figuring that they’ll be in a lower tax bracket then (e.g., after retiring). Of course, it’s impossible to know what tax rates will be in the future or whether employees will be in lower tax brackets (large required minimum distributions from 401(k)s and IRAs may result in higher tax brackets). Nonetheless, for employees who opt for deferral and want to avoid current income tax on year-end bonuses, the deferred compensation arrangement must meet certain criteria. The IRS has an Audit Technique Guide on Nonqualified Deferred Compensation that details what a deferral arrangement must look like to avoid current tax and IRS scrutiny.
Note that deferral does not postpone payroll taxes on the compensation. They are paid when the compensation is earned (i.e., currently) and not when it’s paid out in the future.
Are there other options instead of cash bonuses?
Businesses that want to reward employees for their valiant efforts this year but are short of cash may consider alternative bonus arrangements. These may include various types of stock options if your business in incorporated. The ramifications of these options are discussed in a previous blog.
Whether or not incorporated, there are unlimited opportunities to reward employees. Some no-brainers:
- Time off
- Training and career development
- A promotion (with a new title and higher pay)
- Additions to work-life balance (e.g., flex time; setting up a dependent care flexible spending arrangement to enable employees to pay their childcare on a pre-tax basis)
Remember what Doug Conant, former CEO of Campbell Soup Company, said:
“To win in the marketplace you must first win in the workplace.”
Don’t let the holiday season go by without some recognition and reward for employees. If you don’t know what to pay, consult with your financial advisor now so you can make arrangements before it’s too late.