Avoiding the Pitfalls of Employee Bonuses and Gifts

It's the end of the year, and many employers will be paying employees bonuses or giving them holiday gifts. Even though these may be examples of appreciation provided by employers, these bonuses and gifts can have tax consequences that can be pitfalls if not handled properly.

Regardless of how or when they are paid, all bonuses are defined as supplemental wages. As such they are subject to federal income tax and FICA tax withholding, as well as state and local income tax withholding. The article, The Ins and Outs of Supplemental Wages – How Taxes Are Withheld, describes the correct procedures for withholding taxes from bonuses.

Holiday gifts, on the other hand, are defined as a fringe benefit. Fringe benefits are normally subject to income tax withholding unless they are excluded by law. If a gift to an employee can be defined as a de minimus fringe benefit, then it is not subject to income taxes. IRS Publication 15-B, Employer's Tax Guide to Fringe Benefits, states that “a de minimis benefit is any property or service you provide to an employee that has so little value (taking into account how frequently you provide similar benefits to your employees) that accounting for it would be unreasonable or administratively impracticable.”

De minimus gifts can include such things as fruit baskets, hams, turkeys, wine, flowers, or tickets to a specific show, sporting, or other event. Cash or cash equivalents (such as gift cards) are never excludable. For instance, a turkey may be treated as a de minimus gift, but a gift certificate for a turkey has a cash equivalent, so its value must be added to an employee's wages and taxes withheld.

Why Are Bonuses Designated as Discretionary or Nondiscretionary?

The matter of bonuses is covered in the Code of Federal Regulations (CFR) as part of the overtime provisions of the Code. [29 CFR 778.208-212] Not only are bonuses subject to income taxes, but their payment may affect an employee's overtime pay, depending on whether the bonus is discretionary or nondiscretionary.

The article, What Is Overtime Pay?, clarified the point that overtime pay is based on the employee's regular rate of pay. The regular rate of pay is defined as the employee's total workweek remuneration divided by the number of hours worked in the workweek. The overtime pay is calculated as 50% of the employee's regular rate of pay times the number of overtime hours worked in the workweek. The above definition is important because nondiscretionary bonuses must be included in the employee's total remuneration when calculating the regular rate of pay and overtime.

So What Is a Nondiscretionary Bonus?

A nondiscretionary bonus is one that is paid “pursuant to any prior contract, agreement or promise.” [29 CFR 778.211(c)] For instance, this includes production bonuses that are paid when an employee meets specific goals, or it could include a bonus paid as an inducement to remain in the job. If the employee expects the bonus to be paid for any reason, then it is a nondiscretionary bonus, and its value must be include in the calculation of the employee's regular rate of pay.

“When the amount of the bonus can be ascertained, it must be apportioned back over the workweeks of the period during which it may be said to have been earned.” [29 CFR 778.209(a)] For instance, suppose the employee receives a quarterly production bonus of $1,300. This has to be apportioned over the 13 workweeks of the quarter, so $100 is allocated to each workweek. So for each workweek in which the employee worked overtime, the $100 bonus must be included in the employee's regular rate of pay.

As an example, suppose the employee is paid $15 per hour and he worked 48 hours in one workweek during the quarter. The employee was already paid for the overtime in his regular paycheck as follows:

Total remuneration = $15/hr x 48 hr = $720
Regular rate of pay (Total remuneration divided by hours worked) = $720 / 48 hr = $15/hr
Overtime pay = 8 hr x $15/hr x 50% = $60
Total amount paid = $720 + $60 = $780

At the end of the quarter, the bonus must be included and the regular rate of pay recalculated.

Total remuneration = $720 + $100 = $820
Regular rate of pay = $820 / 48 hr = $17.09/hr
Overtime pay = 8 hr x $17.09/hr x 50% = $68.36

The difference of $8.36 will have to be paid to the employee as supplemental wages. If the employee worked overtime in any other weeks of the quarter, then the regular rate of pay for each workweek will have to be recalculated as well.

What Is a Discretionary Bonus?

This is a bonus that is paid to an employee in recognition of service performed if “both the fact that payment is to be made and the amount of the payment are determined at the sole discretion of the employer at or near the end of the period and not pursuant to any prior contract, agreement, or promise causing the employee to expect such payments regularly.” [29 CFR 778.211(a)] So the bonus must be a complete surprise to the employee. If the employee expects a bonus, then it is not a discretionary bonus.

There is one exception to the above definition. The CFR defines Christmas bonuses and bonuses paid on special occasions as a reward for service, as gifts. [29 CFR 778.212] Gifts, as noted above, are subject to income taxes, but they do not have to be treated as nondiscretionary bonuses, even though employees expect them at this time of year.

So employers are under obligation to carefully determine whether additional cash payments made to employees are discretionary bonuses, nondiscretionary bonuses, or gifts. By doing so employers can avoid the pitfalls outlined above.