Tax Implications of Bonuses

If you get pleasure from rewarding your team's performance with bonuses, you are not alone. But it's important to consider how those bonuses are given, along with the tax implications for both you and the employee.

One-time bonuses are generally calculated by percentages. The rates cluster around 3% to 5% of annual salary for clerical and support staff. Managers might receive in the low-double-digit percentage range and executives in the mid-double-digit range. However, bonuses can also be flat rate.

You can generally deduct the cost of bonuses, assuming the bonus is compensation for services rather than a gift. If you use cash-method accounting, remember that you can't deduct bonuses paid in 2024 on your 2023 tax returns. Accrual-method businesses benefit from the rule that lets them deduct a bonus paid for performance in the past year if the employee receives it within 2 1/2 months of the year's end. If you miss that window, the IRS assumes that the bonus is deferred compensation, which is deductible in the year paid rather than the year earned.

An important caveat is that the 2 1/2-month rule applies only to nonrelated employees. If the employee is your spouse, child, sibling, parent or grandparent, you must deduct the bonus in the year the bonus recipient reports it as income, which most likely is the year it's paid.

Tax considerations
Bonuses are considered supplemental wages. (Other forms of supplemental wages are commissions, overtime compensation, severance pay, awards and prizes, back pay, tips, payments for nondeductible moving expenses, retroactive raises, and payments for accumulated sick leave.) That means that you will withhold the usual FICA and federal unemployment tax as well as any applicable state taxes. The federal income tax withholding amount depends on the total amount of supplemental wages received by the employee during the tax year.

If the supplemental wage payment exceeds $1 million, the first million gets taxed at 22% and every dollar over that is taxed at 37% or the highest income tax rate for the year.

For supplemental wages of $1 million or less, you can choose one of the following methods for calculating tax:

• If you pay supplemental wages with regular pay without specifying the amount of each, 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 with wages and specify the amount of each, you can:
  • Withhold a flat 22% of the bonus. (So if the bonus, paid separately, was $100, you'd withhold $22 and cut a $78 check.)
  • Use the aggregate method — an IRS formula based on the employee's tax bracket (as given on a W-4) — to calculate the amount to withhold. This is a more complicated way to calculate taxes and may better ensure that you cover the employee's tax liability.

If you end up withholding more tax than necessary, the employee receives a refund. If you withhold too little, the employee gets taxed by surprise.

A tax-free bonus is basically impossible. If you pay the employee's share of taxes on the bonus, taxes paid are considered additional wages and are themselves subject to tax.
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You may use bonuses to increase productivity, improve employee retention, thank your team for their efforts and/or create a positive work environment. A bonus is always a welcome bump in pay. You may want to calculate the bonus yourself or consider consulting with your accountant or tax adviser to learn how bonuses affect company and employee taxes.

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