As the end of the year and holidays approach, many employers are giving their employees Christmas or yearend bonuses to show appreciation to them for their work throughout the year. The question that arises for many employers is whether these holiday bonuses are subject to income tax withholding, and if so, how should that be calculated. The IRS refers to these bonuses as ‘supplemental wages’ because they are not regular wages paid to the employee for the work they perform. Fortunately, the IRS provides clarification in IRS Publication 15 on how to withhold taxes on these payments. State rules vary from state to state, so employers would have to check their state laws to determine the amount of state withholdings.
Employees who are paid over 1 million in supplemental wages
Special rules apply to bonuses made to highly compensated employees who earn more than 1 million. The employer is required to withhold at the highest Federal rate (37%), in addition to any applicable FICA and state withholdings.
Employees who are paid less than 1 million in supplemental wages
For employees who are paid less than 1 million in supplemental wages, employers can use several methods to determine withholding.
Combine the bonus with regular wages: When using this method, the employer would not differentiate between the bonus and wages and would simply add the bonus into the employee’s regular payroll run and withhold accordingly as if the total were a single payment for a regular payroll period making sure to withhold any applicable FICA and state withholdings.
Bonus differentiated from regular wages: If you pay a bonus as a standalone or separate payment, or add the bonus as a differentiated amount in a normal payroll run, the IRS provides two methods for calculating the withholding:
Flat 22%: Under this method, the employer would withhold a flat 22% rate in addition to any applicable FICA and state withholdings.
As if regular wages: This method would be similar to #1 above, in which the employer would add the supplemental wages (bonus) to the regular wages and withhold as if a single payment, making sure to withhold any applicable FICA and state withholdings.
Most employers want to give all their employees a flat amount as a holiday bonus. For instance, giving $100 in cash, or a $500 check across the board to all employees. This would be the ‘net pay’ amount after taxes. So, what would be the best way to handle this and figure withholdings since employees all withhold at different rates? In this situation, since the employer is making a supplemental payment that is differentiated from regular wages, the easiest method would be to use the flat 22%. That way they do not have to do separate calculations for each employee based on their respective withholdings.
Most payroll software simplifies these calculations for employers by providing the option to enter the bonus as gross pay, or net pay, and then doing the calculations for them. But for those who run manual payroll, or their software does not provide this function, basically, all the employer would need to do is to ‘gross up’ the payroll based on the amount of bonus they wish to pay. For this we can use a simple formula to back into the gross pay that needs to be run through payroll. [Net Bonus / (1-Sum of all withholding tax rates) = Gross Pay]. For instance, if an employer is giving each employee a $100 bill using the IRS flat 22% method, and the applicable state tax withholding rate is 6%, the amount that would be run through payroll would be $176.37. [$100 / (1-(0.22+0.153+0.06))=$176.37.
Providing year and and/or holiday bonuses to employees is a great way for employers to boost morale, and we hope that this article helps clarify some of the questions you may have. If you have any further questions, or would like a free Excel template to make these calculations, please feel free to click on the button below.
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