Getting gifts and bonuses is great—until someone reaches their hand into your paycheck and pulls a whole bunch of it out (ahem—the IRS)! This sounds unfair but is often what happens with supplemental employee compensation given at the end of the year.
And what’s worse? Most of these gifts aren’t tax-deductible for the employer, either. Unfortunately, the tax implications of an employer’s holiday gift-giving are often among the year-end workplace issues that many employers face.
Before you start writing those checks or handing out those bonuses, you may want to consider how those gifts will affect your tax bill. A few strategic tips could benefit all parties involved.
‘Tis the Season for Tax Breaks?
The general tax rule is that all forms of compensation are subject to income tax unless specifically excluded by the tax code. There are exemptions to this rule, however, when it comes to any fringe benefit that qualifies as a de minimis fringe benefit.
A de minimis fringe benefit is defined as any property or service (never cash or gift certificates) of which the value is so small as to make accounting for it unreasonably or administratively impracticable. This could include small prizes given away at a holiday party or small, material, tangible gifts awarded around the holidays.
But, cash and gift certificates never qualify. Employee gifts in the form of cash or gift certificates/coupons, regardless of the amount, are always treated by the Internal Revenue Service as W-2 “wages” subject to withholding taxes.
So, of course, any significant gift or bonus will not fall under this exemption either. Naturally, the IRS will want their share of the award.
What About Tax Deductions?
The stipulations here are dependent on the business structure and who the bonus is being paid to. The answer is “Yes” for some and “No” for others. Here’s why.
Paying out bonuses to your employees can be an excellent motivational tool or way to compensate employees during the holidays, but only if your company operates through a corporation will your bonus payments be tax deductible. This applies to both cash and personal property for both owners and employees.
As far as business owner bonuses go, the path is divided.
S corporations can deduct bonuses for shareholders and owners, as long as they own their shares at the time the bonus is paid and other corporations can deduct bonuses for corporate officers who are paid employees.
Unfortunately, this is not also the case for small business owners. Bonuses are not deductible for small business owners including sole proprietors, partners, and LLC owners. This is because the IRS considers these owners to be self-employed. The money these business owners pay themselves is considered a draw, not a bonus.
So How Do You Compensate Employees Without Sticking Them with An Extra Tax Bill?
“Gross up” the bonus. In order to make sure your employee isn’t stuck with the tax bill on their own gift, consider “grossing up” their bonus. That is, increase the value of their cash award so they receive the full intended amount of the award after taxes are assessed. For example, if you give an employee a $1,000 bonus, by the time you take out taxes, the bonus check might be only $750. But, you could calculate a higher amount for the bonus so the entire net reaches the intended $1,000.
What’s the Best Way to Compensate Yourself?
Whether your company is an S or a C corporation, all bonuses are treated as wages, so you’ll be expected to pay a 1.45% Medicare tax. You’ll also pay a 6.2% Social Security tax if you haven’t already received the maximum Social Security wages. Finally, you’ll have to add in state and federal income taxes.
These taxes can get pretty hefty, which is why some business owners opt for a self-compensation approach. This involves treating extra payment to yourself as a profit distribution rather than a bonus. However, this is where the roads diverge for C and S corps.
With C corporations, a profit distribution faces double taxation, first as a corporate dividend and then as personal income. Once you add in state as well as federal taxes, you could be paying 55% or 60% of that C corporation profit distribution in taxes.
With S corporations, however, distributions are not subject to federal taxes at the corporate level. So in general, profit distributions generally make more sense than bonuses for owners of S-corps.
Always consult with your accountant and financial advisor before making any bonus or dividend payments to yourself as there are numerous tax risks and penalties tied to anything the IRS deems “excessive owner compensation.”
Choosing the Right Gift
Choosing the right gift is always a difficult choice but can be further complicated when the IRS wants a piece of the pie (oftentimes from both ends). Keeping these income guidelines in mind when choosing how you’ll compensate yourself and your employees will help you avoid handing more over than you’d like to that Ol’ Grinch Uncle Sam.