As the year draws to a close, many employers are deciding whether to give year-end bonuses or gifts to top performers, or perhaps the entire workforce. Whether erring on the side of Scrooge or St. Nick, here are five tips on employee bonuses and gifts that employers should keep in mind.
- Employees must report bonuses as taxable income. Bonuses are considered taxable income, which must be reported on an employee’s Form W-2. Federal, state and local income taxes and FICA taxes must be withheld, the Social Security portion of which is subject to an annual compensation limit (which for 2017 is $127,200). Employers should also be mindful of any gross-up arrangements offered to employees to compensate for additional taxation incurred by the bonus payment, though that is a voluntary additional benefit.
- Employers may deduct employee bonuses under certain circumstances. Bonuses can generally be deducted by the employer if they are ordinary and necessary business expenses. To be deductible, bonuses must be reasonable — as additional pay for services performed rather than as a gift — and paid or incurred in the year in which the deduction is claimed. An “ordinary” expense is one that is common and accepted in your trade or business. A “necessary” expense is one that is helpful and appropriate for your trade or business. An expense does not have to be indispensable in order for it to be “necessary.” Notably, employers can also deduct the costs of a holiday party for employees as a business entertainment cost.
- Gifts are taxable as income unless de minimis. Courts and agencies usually conclude that employer "gifts" are to reward past performance or to provide an incentive for future performance, rather than gifts motivated by disinterested generosity. For this reason, gifts from employers are taxable as income unless they constitute de minimis fringe benefits. A de minimis fringe benefit is property or service given where the value is so small that accounting for it is unreasonable or administratively impracticable. Examples include traditional holiday gifts of property (not cash) with a low fair market value, occasional theater or sporting event tickets, flowers, fruit or books, among others. While there is no bright-line test to determine whether the value of property or services is de minimis, the IRS has previously held that items with a value exceeding $100 could not be considered de minimis even under unusual circumstances. Importantly, de minimis fringe benefits do not cover cash or gift cards that are redeemable for general merchandise or have a cash equivalent value, no matter how small the amount — unless the money or gift card is for meals and is provided only on an occasional basis, such as during the holidays.
- Bonuses may be earned pro rata. If your company has a written bonus plan, review it first. If the terms of a bonus plan are definite, a promise to pay a bonus as an incentive for continued service may constitute an enforceable obligation, rather than a gratuitous benefit. But, where an employer has full discretion to decide whether to issue a bonus and the amount of the bonus, or the terms of the bonus plan are indefinite, a bonus will likely be construed as a gratuity. If a promise to pay a bonus is enforceable, employees in most jurisdictions are entitled to a pro rata share of the bonus if terminated without cause before the distribution of bonuses. Ordinarily, an employee who voluntarily terminates employment is not entitled to any portion of a bonus. Depending on the jurisdiction, an employer may avoid liability to pay a bonus when an employee is discharged before bonuses are distributed if a bonus plan states an employee forfeits his or her bonus if terminated with or without cause prior to the end of the fiscal year.
- Employers should maintain fair bonus practices. Like all compensation, bonuses are subject to equal pay and anti-discrimination laws. To maintain fairness and guard against discrimination, bonuses should be based on objective, identified factors. In addition to an appearance of fairness, disclosing these factors well in advance of year’s end will motivate employees to achieve benchmarks the employer considers valuable.
Please reach out to Taft's Employment Law practice with any questions on this topic.