A few weeks ago, I wrote about how charitable giving is a great way to observe the holidays as a team and shape your company culture in the best possible way. Few tax-deductible expenses pack a stronger punch in terms of making your company a great place to work.
But employee bonuses come pretty darn close.
If you’re a business owner looking to lower your tax obligations for the year, bonuses are a great place to start. There are a couple of ways you can go about spreading the love to your employees:
1. Performance-based bonuses: Some companies (investment banks, most famously) make performance-based bonuses a primary source of employee compensation. Other companies review every employee’s performance at the same time each year to determine who has earned extra compensation by going above and beyond. And some companies hand out bonuses only in special cases, for example, if an employee or team has just finished a major project on schedule and under budget.
Keep in mind: Raises are frequently based on performance as well, but performance-based bonuses are given as a lump sum.
2. Holiday bonuses: You can give a performance-based bonus at any time of the year, including the holidays. But a true holiday bonus isn’t really based on performance—it’s an across-the-board gift to each of your employees. The great thing about holiday bonuses is that they scale so well: Based on your cashflow (and tax needs), you can give everybody $50 or $100 or $1000—everybody will be happy no matter what. Just make sure your employees know the holiday bonus stems from goodwill, not performance.
How Small Businesses Can Claim a Tax Deduction for Holiday Bonuses
Another great thing about employee bonuses is that the tax deduction is so straightforward. Bonuses are considered to be employee wages, which are tax deductible anyway. Here’s what you need to know:
1. It’s easiest to distribute holiday bonuses via your payroll provider. That way, all the usual federal and state withholdings, FICA, unemployment, and other payroll taxes are automatically applied just as they usually are.
2. You can give cash, it just takes a bit more planning. Maybe you want to give all your employees a crisp bill or two. Decide how much you want to give your employees (say $100) and “gross-up” the amount. Grossing up allows you to include estimated taxes so that, after taxes, the amount that’s left is the $100 you want to give your employees.
Before you break out your calculator: Your payroll provider handles this calculation all the time—they can advise you, but they may also have a tool you can use to figure it out yourself. Here’s one from ADP, for example.
3. Record bonuses as wages on your income statement, regardless of which method you choose. Remember: If you use accrual accounting, then on your books, employees accrue performance-based bonuses throughout the year. They must be paid out to employees within 2 ½ months of the end of your fiscal year to claim a deduction for this year (otherwise, you can claim it next year).
4. Yes, you have to pay taxes on bonuses, and so do your employees. It may feel tempting to hand everyone cards with cash and be done with it, but that’s definitely against the rules. To the IRS, it’s the same as blowing off payroll taxes. Also, unreported cash payments are not tax deductible.
One More Option for Bonuses: Retirement Plan Contributions
This may not feel quite as thrilling as a traditional holiday bonus, but there are some significant tax advantages to contributing to your employees’ retirement plans at holiday time (even if you already have a matching plan in place):
1. Your employees don’t report contributions to a 401(k) or 403(b) as income on their W-2 forms, so it’s definitely a better deal for them. In fact, they won’t pay taxes on this form of bonus at all until they begin to withdraw from the account, usually at retirement.
2. As an employer, you won’t have to pay employer payroll taxes, but you’ll still get to claim a tax deduction on your business tax return.
3. According to the IRS, in 2016, employee contributions to a 401(k) or 403(b) are limited to $18,000 ($24,000 for those 50 and older); but the total contribution limit is $53,000 ($59,000 if you’ve already turned 50). So even if your employees are maxing out their personal contributions, they can still accept $35,000 (or $41,0000) from you in matching contributions or bonuses. That gives you a lot of room to lower your taxes and make your employees very happy.