As the year draws to a close and the holiday spirit abounds, employers can anticipate reviewing year-end figures to determine who goes on the naughty or nice list. Whether erring on the side of Scrooge or St. Nick, here are a few points on bonuses and gifts that employers should keep in mind.
1. Employees must report bonuses as taxable income. Bonuses are considered taxable income to be included 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 2013 is $113,700. Employers should also be mindful whether they agreed to a gross-up arrangement with the employee as the employer will have to pay the entire bonus amount and the tax as well.
2. Employers may deduct bonuses under certain circumstances. Bonuses can generally be deducted by the employer if they are ordinary and necessary business expenses. Namely, 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 to be “necessary.” Of note, employers can also deduct the costs of a holiday party for employees as a business entertainment cost.
3. Gift cards are taxable as income unless de minimis. Most gift cards and gift certificates to employees that are redeemable for general merchandise or have a cash equivalent value are taxable as income. Gifts from employers are taxable because ultimately an employer does not provide the gift out of disinterested generosity, but rather to reward past performance or to provide an incentive for future performance. There are, however, de minimis fringe benefits (property or service given where the value is so small that accounting for it is unreasonable or administratively impracticable) that do not constitute taxable income. Nevertheless, de minimis fringe benefits do not cover cash no matter how small the amount. For example, giving a low-cost theater ticket to an employee may not be taxable, but giving the employee the cash for the ticket would be.
4. Bonuses may be earned pro rata. 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 contract, rather than a mere gratuity. But, where an employer has full discretion 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.
5. Identify 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.