TECHNICAL GLOSSARY

Bonus Pay: Definition, Types, and Tax Considerations

Employers commonly use bonus pay as an additional type of compensation (i.e., incentive to meet performance goals, encourage retention, and reward success) to employees. Employees, business owners, and employers must understand how bonuses work (i.e., when they are earned and how they’ll be taxed) for compliance and effective financial planning.

What Is Bonus Pay?

An additional payment to an employee over and above the employee's normal salary is referred to as a bonus. Unlike a wage or salary, however, a bonus is usually not guaranteed and is often given for some type of accomplishment such as: achieving an outstanding level of performance; achieving certain performance objectives; having the company earn a profit; or signing an employment contract. In addition, bonuses can be made as one-time payments or through a program that provides multiple bonus opportunities over time. However, whether or not a bonus is guaranteed to be paid to an employee will depend on the terms of the employee's employment agreement, offer letter, or company bonus policy.

Regarding Common Types of Bonuses

Performance (or output) Bonuses: These bonuses are tied to an employee's performance, either individually, team or company. The general calculation of performance/bonus is through an equation. Bonus amount equals (bonus percentage multiplied by base salary).

For Example: If you are an employee receiving $50,000 as your base salary and get a 10% bonus, then your bonus is $5,000.

Profit Share Bonuses: Employers often share a percentage of profits with eligible employees based on a formula outlined in advance. The general equation is (Company Profit multiplied by Bonus Percentage) divided by all eligible salaries.

This approach aligns employee incentives with overall company/company when employed by a medium-sized business.

Discretionary (or Unrestricted) Bonuses: Unrestricted bonuses are given at the discretion of management and cannot be calculated based on a specific formula or metric. Unrestricted bonuses could be given based on tenured employees, individual employee accomplishments, or outstanding employee performance.

Flat Rate Bonuses: A flat rate ($) bonus is paid to all qualified employees in fixed ($) amounts—regardless of hourly wage or number of hours worked etc.—for example, if every worker received a year-end flat-rate bonus of $500.

Sign on bonus repayment: An employer can have an employee who leaves his/her company before a specific period of time to repay the sign on bonus; however, this requirement must be written into the employment agreement and clearly defined when hiring for that position/employee.

In order for the employer to request repayment of a bonus:

• Review the Employment Agreement
• Communicate to the employee

Are Bonuses Taxable?

The IRS defines bonuses as additional income as well as they will be subject to tax withholdings, by the employer. These withholdings include;

• Federal taxes
• State taxes (if applicable)
• Social Security tax
• Medicare tax

Ways to Reduce the Tax Impact of Bonuses

Employers and employees may reduce their tax impact through non-cash bonuses (subject to IRS valuation rules), strategically timing bonuses in the tax year, and allowing employees to defer receiving their bonuses until they can be paid for under a qualified retirement plan (401(k), etc.) if they so choose.