Taxing a Bonus or Commission
There are tax implications to consider when issuing bonuses or commissions. The IRS considers bonus and commission payments as "supplemental wages" to an employee's regular wages. In its Employer's Tax Guide, the IRS defines supplemental wages to include, but not limited to, "bonuses, commissions, overtime pay, payments for accumulated sick leave, severance pay, awards, prizes, back pay, retroactive pay increases, and payments for nondeductible moving expenses. Other payments subject to the supplemental wage rules include taxable fringe benefits and expense allowances paid under a nonaccountable plan."
In this article
- How Taxes are Calculated on Bonuses or Other Supplemental Wages
- Net Bonus Amounts
- Supplemental Wages Combined with Regular Wages
- Supplemental Wages Identified Separately from Regular Wages
How Taxes are Calculated on Bonuses or Other Supplemental Wages
How bonuses and other supplemental wages are taxed largely depends on how they are paid. If you pay a bonus on a single check along with an employee's other regular wages, then you can allow the standard payroll tax tables that are driven by an employee's W-4 election to dictate the withholding. However, if you separate the supplemental wage payment out from the employee's regular wages, then the IRS says to withhold Federal income taxes at a rate of 22% (previously 25%). Therefore, if you pay someone a $5,000 bonus, you will withhold $1,100 for Federal income tax alone. In addition, you are required to withhold State and local income taxes (Colorado at 4.63%), Social Security at 6.2% (wages up to $137,700 annually for 2020), and Medicare at 1.45% (for YTD wages below $200K annually, then an additional 0.9% of wages over $200K).
Why is this? At this point, we can only theorize as we've never seen anything from the IRS detailing the rationale for this supplemental tax rate. Our assumption is that the tax rule is designed to ensure that sufficient withholding is taken out of supplemental payments so that employees don't have a tax surprise the following April. The impact for many employees of this supplemental tax rate can be an overfunding of their personal income taxes, which leads to a personal tax refund. For an employer, there is zero impact from an expense standpoint. An employer should NOT deviate from the IRS tax guidance on supplemental wages and should choose one of the two common options for taxing.
Net Bonus Amounts
When an employer wishes to give an employee an after-tax net bonus, things get complicated. Since the IRS supplemental tax rate is 22% and can lead to employee's earnings being overwithheld for the year, we advise employers to shy away from net bonuses and instead settle on a gross amount for the bonus.
If you wish to give an employee a $1,000 net bonus, you will need to pay a gross bonus of $1521.61 to accommodate supplemental wage taxes (22% fed, 4.63% state, 6.2% Social Security, 1.45% Medicare). That's 34.28% in taxes that you, as an employer, will be covering in addition to the net bonus payment and not including another 7.65% or more in employer taxes.
Frustrating? Yes, particularly if you know your employee is in a relatively low- or middle-class personal tax bracket and may have various dependents and other tax breaks. But remember, you do not want to give your employees personal tax advice. At some point, you must settle on a gross amount for the bonus and determine if the payment should be combined with the employee's regular salary/hourly wages or taxed using the flat supplemental wage percentages. Either way, the employee is being rewarded with a bonus; make sure you discuss with them the gross amount as that is their true reward, not the net result after taxes.
Supplemental Wages Combined with Regular Wages
Here are the details from the IRS: "If you pay supplemental wages with regular wages but do not specify the amount of each, withhold federal income tax as if the total were a single payment for a regular payroll period."
Supplemental Wages Identified Separately from Regular Wages
If you pay supplemental wages separately (or combine them in a single payment and specify the amount of each), the federal income tax withholding method depends partly on whether you withhold income tax from your employee's regular wages.
If you withheld income tax from an employee's regular wages in the current or immediately preceding calendar year, you can use one of the following methods for issuing the supplemental wages:
a. Withhold a flat federal tax rate of 22% (no other percentage allowed)
b. If the supplemental wages are paid concurrently with regular wages, add the supplemental wages to the concurrently paid regular wages. If there are no concurrently paid regular wages, add the supplemental wages to either the regular wages paid or to be paid for the current payroll period, or the regular wages paid for the preceding payroll period. Figure the income tax withholding as if the total of the regular wages and supplemental wages is a single payment. Subtract the tax withheld from the regular wages. Withhold the remaining tax from the supplemental wages. If there were other supplemental wages paid during the payroll period made before the current payment of supplemental wages, aggregate all the payments of supplemental wages paid during the payroll period with the regular wages paid during the payroll period, calculate the tax on the total, subtract the tax already withheld from the regular wages and the previous supplemental wage payments, and withhold the remaining tax.
If you did not withhold income tax from the employee's regular wages in the current or immediately preceding calendar year, use method "b" described above. This may occur, for example, when the value of the employee's withholding allowances claimed on Form W-4 is more than the wages.
Regardless of the method you use to withhold income tax on supplemental wages, they are subject to Social Security, Medicare, and FUTA taxes.
If you are still reading at this point, you might have a headache. We're here to help! If you're an ASAP payroll client, feel free to discuss these options with your account manager.