Year-End Bonuses: Tax Issues for Employers and Employees

The holidays are often referred to as “the most wonderful time of year” — and, for some people, that’s due in part to their year-end bonuses. While bonuses are an important part of rewarding employee performance and enhancing retention, they also can raise a variety of tax issues for both employers and employees. Here’s what you need to know if you give or receive a bonus.

Deducting Bonuses Paid to Employees

Employers generally can deduct the cost of bonuses paid to employees before year end, assuming they represent compensation for services rather than a gift. Tax regulations may complicate matters for bonuses paid after year end, though.

For employers that use cash-method accounting, it’s simple — they can’t deduct a bonus paid in 2024 on their 2023 tax returns. However, accrual-method businesses may have some breathing room. Under the 2½-month rule, those businesses can deduct a bonus paid for performance in one year if the employee receives it within 2½ months after year end. After that time, the IRS presumes the bonus is deferred compensation, which isn’t deductible in the year earned but only in the year it was actually or constructively paid.

The 2½-month rule applies only to nonrelated employees. If the employee is the employer’s spouse, child, sibling, parent or grandparent, the business must deduct the bonus in the year the bonus recipient reports it as income, which is most likely the year it’s paid out.

The Employee’s Side of the Story

As an employee, you generally must report a bonus as income in the year you receive it, regardless of the form it comes in (for example, cash or cryptocurrency). It’s irrelevant when you deposit it because, in the eyes of the IRS, it’s your income as soon as it’s made available. On the other hand, if you receive a bonus after the New Year in recognition of your 2023 performance, it’s taxable for 2024, not 2023.

Could a substantial bonus push you into a higher tax bracket? This may be an unavoidable side effect of a major payout, but, under our marginal tax system, the higher rate will apply only to your taxable income that exceeds the relevant threshold. For example, if you end up in the 32% tax bracket in 2023, the 32% rate applies only to your taxable income in excess of $182,100, not your entire taxable income.

What can you do to reduce your tax liability from a substantial bonus? There are several options. For example, you could invest your bonus in your 401(k) or health savings account (HSA). You also could increase itemized deductions, if you claim them, by taking steps such as donating to charity. But pay close attention to the relevant deadlines for such tax-planning moves to apply for 2023. If you expect to have less taxable income next year (for example, because you plan on retiring), consider asking your employer to defer the bonus into 2024 so you’ll pay a lower tax rate on it.

Withholding Rules

Federal income taxes must be withheld from bonuses, similar to regular wages. But different rules come into play, because bonuses are considered “supplemental wages.” Other examples of supplemental wages include:

• Commissions,
• Overtime compensation,
• Severance pay,
• Awards and prizes,
• Back pay,
• Tips, and
• Payments for nondeductible moving expenses.

Employers need to withhold the usual FICA taxes — meaning the 6.2% Social Security tax and the 1.45% Medicare tax — and the federal unemployment tax. The federal income tax withholding amount depends on the total amount of supplemental wages an employee receives during the tax year.

Here’s how it works: If a supplemental wage payment, together with other supplemental wage payments made to the employee during the calendar year, exceeds $1 million, the excess is subject to withholding at 37% (or the highest rate of income tax for the year). You should withhold at that rate even if the employee’s Form W-4 indicates otherwise. The regular withholding rules apply to the amount under the $1 million threshold.

Additional Rules

The following rules also apply for supplemental wages of $1 million or less:

• If you pay supplemental wages with regular wages without specifying the amount of each, you should 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 and specify the amount of each), you can 1) withhold a flat 22% of the bonus, or 2) use the aggregate method (an IRS formula) to calculate the amount to withhold.

Be aware of state income tax withholding obligations, too.

If the employer withholds more than turns out to be necessary, the employee will receive a refund. Conversely, withholding too little could leave the employee with an unexpected tax bill.

What if you pay the employee’s share of taxes on a bonus? In that case, the taxes paid are considered additional wages to the employee and are subject to payroll taxes. So, a tax-free bonus is basically impossible.

Plan Ahead

Most taxpayers know that good intentions don’t cut it with the IRS. We can help you cover your bases when it comes to the tax issues related to year-end bonuses — whether you’re an employer or an employee.

This article appeared in Walz Group’s November 13, 2023 issue of The Bottom Line e-newsletter, produced by TopLine Content Marketing. This content is for informational purposes only.