By: Jay Mittelman
The end of the year is known for the onset of the holidays, parties, gift-giving and ringing in the new year. It’s also the time for tax planning.
Individuals and businesses often can lower their tax bills by accelerating deductible expense, postponing taxable income to the next year — or both. In other instances, more sophisticated tax planning is required.
Naturally, your business plans may include year-end bonuses paid to employees, including, possibly, yourself. Generally, bonuses are tax deductible in the year they are paid and taxable to the recipient in the year they are received. But other tax issues may ensue.
Bonuses typically are paid for a job well done or work that goes above and beyond what is required. In some cases, payment of a bonus may be a contractual obligation or be triggered by a specific event, such as exceeding a stated profit objective.
While they are often paid at the end of the year, the timing can be critical when it comes to taxes.
Basically, the IRS treats bonuses as supplemental wages. The term refers to compensation in addition to an employee’s regular wages, including, but not limited to, severance or dismissal pay, vacation pay, back pay, bonuses, moving expenses, overtime, taxable fringe benefits and commissions. As a result, bonuses are treated differently from ordinary wages or salary for income tax withholding.
When bonuses are paid out at the end of the year, employers may choose one of two income tax withholding methods.
The IRS has authorized a flat withholding rate of 25% on bonuses and other supplemental wages. So, for instance, if an employee is entitled to a $10,000 bonus, the tax withholding is $2,500. Under this approach, the bonus is effectively “singled out” from other wages. Employers frequently choose the percentage method because it is convenient and is usually preferred by employees.
The aggregate method requires additional number crunching and may take a bigger income tax bite out of a bonus check. With this method, the employer adds the amount of the bonus to the employee’s most recent regular paycheck. Then it determines the normal withholding amount, based on IRS withholding tables for the sum of both amounts, subtracts the amount already withheld from the last paycheck and withholds the remainder from the bonus amount.
The main drawback to the aggregate method for employees is that they generally are taxed at a higher rate on the aggregate amount than they normally would be under the flat 25% rate. This means that employees may be overwithheld on their bonuses. Instead of having extra money to buy gifts during the holiday season, an employee can’t recoup the excess withholding until he or she files a tax return the following year.
Other special income rules may come into play. For instance, the IRS requires employers to impose an even higher tax rate on bonuses exceeding $1 million. In this case, the usual 25% rate applies to the first $1 million of the bonus and the highest marginal tax rate — currently, 39.6% — applies to the rest. If a high-ranking executive is due a bonus of $1.1 million in 2015, $39,600 (39.6% of $100,000) is added to $250,000 (25% of $1 million). That adds up to a total withholding tax of $289,600. (The employer may use the aggregate method in lieu of this simplified rate structure.)
When it comes to the timing of bonuses, employers and employees are often on opposite sides of the fence. Generally, an employer using a calendar tax year wants to pay bonuses before the close of the year, so it can deduct the bonuses in the current year. If an employer pays all its year-end bonuses on December 31, 2020, the entire amount is deductible on its 2020 tax return.
Conversely, employees may benefit if bonuses are pushed into the following year. If an employer pushes the bonuses forward just a few days to, say to January 4, 2021, the money isn’t taxable to employees until they file their 2021 returns – in 2022. Of course, in this instance, the employer can’t deduct the bonuses until 2021.
These tax aspects may be factored into an employer’s decision on when to reward employees with bonuses. Consult with your tax adviser.
Unique Tax Break for Accrual-Basis Companies
There’s a special tax break on the books for accrual-basis companies operating on a calendar tax year.
For these employers, bonuses are currently deductible as long as they are paid within 2½ months of the close of the tax year.
In other words, an accrual-basis company can pay bonuses as late as March 15, 2021 and still deduct those bonuses on its 2020 return. Bonuses paid to employees in 2021 before the March 15 deadline are taxable in 2021, not 2020.
The catch: This rule doesn’t apply to bonuses paid to majority shareholders of a C corporation or certain owners of an S corporation or a personal service corporation. Bonuses paid to these individuals are deductible only in the year in which they are paid.