With the new year comes potential new hires, and employers across industries and tax statuses should know how to approach salaries and bonuses to ensure a financially healthy organization. Below, SST Tax Supervisor Velma Garcia outlines several key scenarios for employers to consider.
From an employer perspective, bonuses are often preferable to higher salaries because they are generally self-limiting costs. It’s much easier to offer a bonus than to bump up the employee’s salary for the duration of their employment. An employer can give out bonuses when it has a year of strong sales, and halt that practice during a year in which sales drop.
A higher salary or raise, by contrast, is generally riskier, because an employer is locking themselves into a longer-term commitment. Even if an employer decides not to give a bonus in future years, they’re still required to keep up with preexisting salaries, regardless of how the company is performing. Furthermore, because certain benefits, such as 401(k) matching dollars, are often tied directly to salary, increasing set compensation can also cost an organization in other ways.
A nondiscretionary bonus is paid because of a contract or agreement that has been made between the employer and employee ahead of time and is usually associated with production, quality, attendance or another form of performance. This type of bonus is expected to be paid to meet the terms of the contract or agreement and is usually given at a set time, either monthly, quarterly or annually. Such a bonus is nondiscretionary because the employee knows about and expects the bonus. There should also be a clear understanding of how the employee will earn the bonus and whether the employer has the option to not pay the bonus.
Also worth considering is an employer’s process for determining future raises. Most employers calculate raises as a percentage of current pay. By offering bonuses, as well as other benefits and perks, instead of a higher base pay, employers are avoiding a commitment to higher payroll costs year-to-year. For example, consider the following:
- Scenario 1: Employee is hired with a flat salary of $110,000/year
- Scenario 2: Employee is hired with a flat salary of $100,000/year + $10,000 bonus
The employee receives $110,000 total for year 1, either way. However, if a raise is considered down the road, the base makes a difference. A 10% raise for Scenario 1 would be an $11,000 increase ($110,000 x 10%), whereas a 10% raise for Scenario 2 would only be $10,000 ($100,000 x 10%).
From a tax standpoint, an employer will have to remit the same amount of Federal Insurance Contributions Act (FICA) taxes (Social Security and Medicare), as well as unemployment taxes in the form of a salary increase or bonus. The only difference is timing. With a higher salary, those taxes are remitted uniformly throughout the year based on reporting requirements. With a year-end bonus, the taxes are lumped into the last reporting period.
Another tax consideration is whether a bonus can be recorded on the books and a tax return at the end of the year.
Cash method taxpayers must claim the deduction for the salary, wage or benefit payment in the same year it’s paid to the employee. If you’re a cash method taxpayer, you must have paid the bonus before the end of your tax year in order to deduct that same year.
Accrual method taxpayers claim the deduction for the year in which the obligation to pay is established and when the services are performed, even if the actual paycheck is distributed later. Accrual method taxpayers can deduct the bonus paid to a non-related employee in the tax year in which they established the amount and the employee’s right to the bonus. If you use the accrual method, you may be able to deduct a bonus in one tax year if you pay it within two months and fifteen days following the close of the tax year.
Finally, variable pay like bonuses and incentives allow employers to use their compensation dollars to attract qualified workers for hard-to-fill positions and retain workers in valuable roles.
For more information regarding payroll, salaries, bonuses or benefits, contact the experts at SST today.
Special thanks to SST Tax Supervisor Velma Garcia for providing the content for this post.