Year-End Business Tax Planning Employee Bonuses (2024)

FAQs

Year-End Business Tax Planning Employee Bonuses? ›

There is a tax rule that permits your business to deduct employee bonuses in the previous tax year if bonuses are paid within 2½ months after the end of that tax year. The business gets a needed tax deduction now and your employees don't need to report the income until the following tax year.

Since the IRS views bonuses as supplemental income, employers must withhold taxes on bonuses according to IRS regulations for supplemental income, which is a separate withholding calculation than your regular wage or salary pay.

Deducting Bonuses Paid to Employees

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

Before you start making plans to spend it, it's important to understand how that income will get taxed. Yes, your bonus money is taxable—typically at a flat rate of 22%—and it's up to you to make sure the appropriate amount gets paid.

First and foremost, bonuses are taxed because they are considered taxable income. But the IRS also considers bonuses to be supplemental wages. Essentially, supplemental wages are types of wages, e.g., overtime, commissions, etc., that aren't regular wages.

There's no legal way to pay employees bonuses without taxes.

The 2.5 Month Rule Requirement

In certain circ*mstances, businesses can deduct bonuses employees have earned during a tax year if the bonuses are paid within 2½ months after the end of that year (by March 15 for a calendar-year company). First, only accrual-basis taxpayers can take advantage of the 2½ month rule.

An effective bonus strategy clearly describes the process for giving variable compensation. You can include the bonus with regular wages or pay it separately. If you put the bonus on an employee's regular paycheck, you withhold taxes based on the total amount.

According to the rule, an expense is incurred and deductible in the tax year if it meets the “all-events test” and the economic performance in question occurs within 8½ months after the close of the tax year.

Do you have to withhold 22% on bonuses? ›

Bonuses are taxable income, but the IRS considers them supplemental wages, which means taxes may be withheld on your bonus differently than they are on your ordinary wages. Employers can either tax your bonus at a flat 22% rate or use a more complex withholding calculation.

Your bonus will be taxed, but you can lower the amount of your taxable income by depositing some or all of it in a tax-deferred retirement account such as a 401(k) or IRA. However, this does not mean you will avoid paying taxes completely.

A bonus is always a welcome bump in pay, but it's taxed differently from regular income. Instead of adding it to your ordinary income and taxing it at your top marginal tax rate, the IRS considers bonuses to be “supplemental wages” and levies a flat 22 percent federal withholding rate.

Accrual-basis taxpayers only

If your business uses the cash method of accounting, you must deduct bonuses in the year they're paid, even if they're earned in the previous year. To accelerate bonus deductions into this year, your business must be on the accrual method of accounting.

“If they just raise our salary, we're not going to be taxed so heavily on that. Plus there's no guarantee year-to-year what they're going to do,” she said. Bonuses can be taxed at a higher rate than normal wages, though there are some ways to mitigate that, and you might wind up getting a refund.

A bonus is taxed using a percentage method or an aggregate method. The flat tax rate for a bonus is 22%. You can minimize your tax burden by having your employer withhold taxes from each paycheck above your tax bracket, utilizing all available deductions, and taking advantage of qualified investments.

You cannot claim exemption for bonuses. Maybe your employer changed the payroll company or the payments were classified differently. What was your total income last year? No taxes would be withheld if total income + the bonus were bellow the filing/withholding requirement.