Paying bonuses to employees around the winter holidays is a common practice in businesses of all sizes. Many employers use holiday bonuses to boost morale among their team and thank employees for a good year.
According to the Internal Revenue Service (IRS), some types of bonuses are taxable. Employers need to understand how to meet their tax obligations when awarding year-end bonuses. This guide will help you do so.
What Is a Holiday Bonus?
A holiday bonus is a gift employers award to their employees around the winter holidays. This bonus is not part of an employee’s standard salary or hourly pay and is usually a one-time occurrence.
There are two types of bonuses employers can award:
- Discretionary: These bonuses are awarded at the employer’s discretion, meaning employees do not expect them. For example, granting a surprise bonus at the end of a profitable year would be discretionary.
- Non-discretionary: Employers set out clear criteria for obtaining this bonus. Employees who meet these requirements should expect to receive these bonuses. Overtime pay for non-exempt employees is an example of a non-discretionary bonus.
Holiday bonuses typically fall under the category of discretionary bonuses unless they occur regularly. Non-discretionary bonuses are usually performance-based and appear as part of an employee’s regular paycheck.
Holiday Bonuses vs. Year-End Bonuses
If your company offers both holiday and year-end bonuses, employees may be confused about the difference between the two. Generally, year-end bonuses are recurring non-discretionary payments, like performance bonuses, while holiday bonuses are one-time discretionary gifts. Many employers will distribute extra profits at the end of a good year as holiday bonuses.
The method of calculating how much each employee should receive in a year-end bonus varies across businesses. Some employers award a flat rate every year, while others increase bonuses each year an employee stays with the company. Others offer bonuses based on employee performance.
If your company wants to award both types of bonuses, it’s best to ensure your employees know which one they are receiving and when. One way to clear up confusion is to stagger the bonuses. Time them so that they will be different awards. For example, you could distribute holiday bonuses in late November or early December and year-end bonuses in late December or early January.
How to Pay Bonuses to Employees
How employers award holiday bonuses varies widely across businesses. Some companies give small fixed bonuses of $50 to $100 in gift cards, while others may add a percentage of their employee’s salary to their regular paycheck. The most common methods of awarding monetary bonuses include:
- A separate check
- Money added to employees’ paychecks
- Physical gift certificates or debit cards
You can also award bonuses in forms other than money. Extra paid time off or personalized gifts are common ways employers can give back to their employees around the holiday season.
Do Employers Pay Taxes on Bonuses?
The IRS considers monetary bonuses to be supplemental income, so the tax rate for a holiday bonus will be different from that of regular wages. Most monetary bonuses are taxable, including physical gift cards and certificates. However, this depends on the type of bonus awarded. Specific non-discretionary bonuses may be tax-deductible.
Even holiday bonuses intended as gifts are not tax-deductible. You must report any discretionary monetary bonuses as taxable income on an employee’s W-2 form. The same goes for paid time off, which carries the same tax consequences as an employee’s regular work hours.
The IRS considers small non-monetary bonuses, like holiday gift baskets, to be de minimis fringe benefits, meaning their value is so small they are not worth taxing. If you know awarding a monetary bonus to all your employees might not be feasible this year, consider offering something small like a company logo gift instead.
How to Determine Bonus Taxes
Since the IRS classified employee bonuses as supplementary income, the flat rate of 22% federal income tax will apply for any compensation separate from a regular paycheck. The following taxes can also apply to holiday bonuses:
- State taxes: Depending on your state’s income tax policy, you might need to withhold some money to meet this requirement.
- Retirement plans or 401(k): Depending on how much you usually withhold for retirement plan contributions, you might need to withhold that same amount for your employee’s holiday bonus.
- Federal Insurance Contributions Act (FICA): Around 6.2% of an employee’s paycheck goes to Social Security, and 1.45% goes to Medicare. The Social Security tax only applies to the first $142,800 an employee earns, but the Medicare tax applies to all earned income.
As the employer, you can manage bonus taxes using one of two methods:
- Percentage method: This method follows the IRS’s 22% requirement. It applies to all forms of supplemental income, including commissions and overtime.
- Aggregate method: If you choose to add your employee’s bonus to their normal paycheck, you will use this method. According to the information on your employee’s W-4, you’ll withhold tax from both the bonus and the regular earnings, resulting in a higher withholding than usual.
The percentage method is usually less complicated, but the aggregate method could work better for certain companies.
Additionally, account for holiday bonuses in advance by including them in your yearly expenses. Keeping these records can prepare you for the upcoming tax season and serve as a reference for the next year. A tax attorney can help you save time by untangling the nuances of preparing for tax season, so consider reaching out to one for additional assistance.
Holiday Bonus Tips and Best Practices
When it comes to holiday or year-end bonuses, you should apply the same rules to every employee and be transparent. Your workers should understand how bonuses work. If yearly bonuses are a normal occurrence at your business, make sure your employees understand the following:
- What kind of bonus employees should expect
- When you will distribute bonuses
- How much employees should expect to receive
- How you calculate bonuses
- Any conditions that would prevent an employee from receiving a bonus
Make this information easily accessible for every individual by including it in the handbook.
If, for any reason, you need to eliminate bonuses or change the type of bonus you award, give your employees proper advance notice. You should always explain that one-time holiday bonuses are singular events to avoid disappointing your team in later years.
Navigate Holiday Bonuses With Polston Tax
The holiday season is a great time to give back to your team. Polston Tax Resolution & Accounting is here to help you through the tax process so you can reward your team without stress. Schedule a free consultation online or call us at 844-841-9857 to speak with one of our experienced team members today.
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