Understanding Taxation on Employee Bonuses

It seems simple enough: people like to get paid, and paying workers out of profits or a pre-existing budget has fewer logistics than setting up benefits programs. But when employees get additional payments separate from their regular pay, both employees and employers need to deal with the tax implications of bonuses.

Here are the facts about taxation on employee bonuses that employers and payroll professionals need to be aware of.

What Constitutes an Employee Bonus?

Most bonuses are production-based, such as receiving a percentage of a unit's sales at the end of the year or quarter. According to the Bureau of Labor Statistics, just 12% of private sector employees in 2022 had access to annual bonuses. 41% had access to bonuses not explicitly related to productivity, like meeting a sales target. These bonuses include but are not limited to:

• Annual bonuses, if not tied to profit-sharing
• Longevity bonuses based on seniority
• Holiday and end-of-year bonuses
• Birthday bonuses
• Contract signing incentives
• Recognition bonuses
• Referral incentives
• On-the-spot bonuses, like those paid to get through a tough project or current events

The IRS considers these bonuses to be supplemental wages. No matter what the machinations are behind the vast majority of bonuses, like thanking an employee for years of service or giving them a few hundred dollars in an on-the-spot bonus, they're treated fairly uniformly as far as taxes go. The bonus gets reported in Box 1 of the employee's W-2 form.

Noncash performance-based bonuses, such as paying for an employee's vacation for smashing a sales goal, must also be added to the employee's Form W-2 based on their fair market value. If the fair market value of the vacation is $5,000, then $5,000 needs to be reported as part of the employee's total compensation.

Exception for Employee Achievement Awards

Most bonuses and awards are taxable, whether they're cash, gift cards, or goods and services. However, the IRS has an exception for noncash employee achievement awards. This would be the classic "gold watch for 30 years of service" type of award that is specifically for length of service or safety-related achievements.

You need to give the employee a "meaningful presentation" of their award, like a dinner or award ceremony. You can deduct the cost and the employee can exclude up to $1,600 from their income in this type of reward.

The award doesn't get this "employee achievement" designation from the IRS if the employee received it for less than five years of service or already received a longevity-based reward in the past four years. Safety-related awards don't count if more than 10% of eligible employees received similar awards in the past year.

How Employers Can Handle Withholding on Bonuses

Employers have two options for supplemental wage taxation:

Percentage (Flat Rate) Method

The percentage, or flat rate, method is the more popular method of the two for bonus tax rates. It's the easiest option for employers because it's a flat bonus tax rate set by the IRS based on the current federal income tax brackets. For 2023, the bonus flat tax is 22% for all bonuses accrued and paid throughout the year that are under $1 million. For bonuses exceeding $1 million, the withholding rate is 37%.

This rate is designed to cover both income and payroll taxes and when you pay bonuses to employees separate from their regular paychecks.

If Employee A receives a $10,000 bonus, $2,200 is withheld in federal taxes on the bonus check. If Employee B receives a $1.5 million bonus, the 22% rate applies to the first $1 million with $220,000 withheld. The remaining $500,000 is subject to 37%, $185,000, making the total withheld $405,000.

Aggregate Method

The aggregate method is designed to combine bonus payments with employees' regular paychecks. It's also tailored to each employee based on the withholding instructions from their W-4 forms, such as filing status, number of dependents, and additional withholding requested by the employee.

The flat rate is more popular with employers because it's easier to calculate, but it can lead to headaches for employees. Employees above the 22% bracket can see larger tax bills, while employees at or below 22% have to wait until tax season to get the extra money. The aggregate method more accurately encapsulates each employee's financial situation and also gives them the convenience of one payment.

How Exact Payroll Ensures Accurate Taxation and Compliance

A common mistake with withholding bonuses is that the incorrect rate is used, or it tends to get neglected altogether. Fortunately, there are tools for supplemental wage taxation to ensure that employees aren't hit with surprise tax bills and employers don't have to pay onerous IRS penalties.

Looking for a streamlined solution to manage employee compensation and ensure accurate tax withholdings? Explore how Exact Payroll can simplify your bonus taxation process. Get in touch today!