With the holiday season upon us, now is the time of year that businesses begin to consider year-end bonuses to reward their employees for their hard work and what was hopefully a successful year. These bonuses can have a significant tax impact on both the employer (business owner) and the employee.
Employer
Bonuses are a great way to show your employees that you value their contributions and to reward them for their efforts throughout the year. Bonuses also allow the employer to reduce its taxable income at year-end, making the true after-tax cost of the bonus much less than the actual amount expended.
Bonuses are like any other form of compensation to an employee in that they will create a deduction for a business. As such, a business owner should always consider the after tax cost of the bonus when making the decision on whether or not to pay out bonuses in the current year.
For example, if a business owner has $250,000 of taxable income from his S Corporation or Partnership this year, and is in a combined Federal/State tax bracket of 53% (39.6% Federal and 13.4% State and City), a bonus pool of $50,000 will save him $26,500, making the after-tax costs of the bonus only $24,500. If the bonus pool is large enough, the business owner may even be able to push themselves into a lower bracket and generate even more savings.
For the cash basis employer, the bonus must be paid by December 31, 2014, while an accrual basis employer can accrue the bonus and deduct in the current year as long as it is paid within 2.5 months after the year-end. This accrual can help ease cash flow concerns and can also help to accommodate a common employee request, the deferral of a bonus into a future tax year.
Employee
Employees will always consider bonuses as a factor in evaluating their compensation package offered from an employee. In some foreign countries, particularly in Latin America, bonuses are even required by law.
Bonuses are taxed as ordinary income for the employee, but often are withheld at special rates – more often known as the percentage method. The IRS, per Publication 15, requires that bonuses be withheld at 25%, regardless of the filing status for the employee. This can result in tax consequences of either over or under withholding depending on each employee’s tax situation. Most states have a similar statute in place for bonuses.
A popular tax planning move for individual tax payers relates to the deferral of bonuses. It is not uncommon for employees who are getting a bonus to ask their employer to hold the bonus until January so they can defer paying tax on it until the following year. As mentioned above, for accrual basis taxpayers, this is not a problem; however, cash basis taxpayers may be hesitant since they would like to accelerate deductions in the current year.
Edward McWilliams, CPA
Partner
Ed is a Partner in the firm’s tax and business advisory practice focusing on providing services to middle market private companies across different industries as well as to early stage startups. Ed has over a decade of experience providing tax and business consulting services to these companies of different sizes and across different industries, bringing a broad and diverse knowledge base and strategic solutions to the many complex issues that businesses face.