How Employee Bonuses Are Taxed by the IRS

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Please note that the information contained in this article is limited in scope and is only intended as a high-level overview of the topics discussed. The information is current as of the publication date only, and the laws (and associated agency and/or judicial interpretations) on the topics discussed could change at any point in the future. Square, Inc. (including its affiliates, subsidiaries, employees, officers, directors, attorneys, and tax advisors) undertakes no obligation to update this article for future changes in the law. In addition, laws vary by jurisdiction, and this article does not attempt to address all jurisdictions — for example, states, counties, or cities often have requirements that differ from federal law. Nothing in this article is or should be used as tax or legal advice. In particular, this article cannot be relied upon for the purposes of avoiding taxes, penalties, or other obligations under applicable law. For guidance or advice specific to your business, consult with a qualified tax or legal professional.

When you want to reward your team for a job well done, there’s little employees appreciate more than a bonus. While employee bonuses may be an effective way to build employee loyalty and boost morale, it’s important to understand the unique tax rules that come with them.

So, how are bonuses taxed? Continue reading to learn about the bonus tax rate and how it applies to your business and your valued team.

How the IRS treats employee bonuses

At tax filing time, the IRS treats bonus income just like any other income. But for tax withholding, which is the amount retained by employers for taxes when the bonus is paid, the rules work differently. That means both employees and employers should be prepared for a different process for bonuses than what’s typically experienced with regular payroll.

Bonuses are considered “supplemental wages” by the IRS. Commissions, overtime pay, accumulated sick leave, severance, back pay, reported tips, and other irregular payouts may also be considered supplemental wages for tax withholding.

When an employee receives a raise, where a pay increase is ongoing, it’s treated differently than a bonus. In the next section, we’ll look at the two options you have to handle tax withholding for bonuses.

The IRS rules on the two withholding options

The rules for federal tax withholding give employers two options when paying bonuses to employees who earn less than $1 million per calendar year. Depending on how you pay out the bonus, you have to calculate withholding differently.

(Some payroll providers can help you run a bonus payroll and automatically withhold the correct amount of taxes.)

The first option is to combine your employee’s bonus with their regular wages, though that means the regular wages for that pay period may have to be withheld at a higher amount, based on the total amount paid. The second option is to split the bonus from regular wages, which gives you another choice to calculate withholding.

Flat percentage method: The easiest method to use is the flat percentage method. As of 2020, this requires withholding a flat 22% of the bonus for taxes.

Aggregate method: With the more complex aggregate method, supplemental wages and regular wages are both considered when calculating withholdings. The bonus withholding takes regular pay withholdings into account in a way that could lower what’s withheld for the bonus.

If an employee earns $1 million or more per year in supplemental wage income, any income over the $1 million threshold is withheld at a 37% rate.

How the IRS taxes employees

When it comes time to file an annual tax return, employee bonuses may be taxed in these three ways:

Federal taxes: Federal taxes are calculated based on total annual income and are usually due in April. Here are links to the 2020 and 2021 tax brackets.

Federal FICA taxes: In addition to regular income taxes, bonus income is subject to Social Security and Medicare tax. Often referred to as payroll tax, you may see it listed as FICA on a pay stub, which is short for Federal Insurance Contributions Act. Employees who earn over $200,000 are subject to additional Medicare taxes of 0.9%.

State taxes: Unless employees live and work in a state with no income tax, they should count on paying state taxes as well.

How the IRS taxes employers

Federal tax withholding for bonuses may work differently than regular pay, but the total tax due on the employer side is the same, regardless of how the employee is paid.

Employer payroll taxes make up the rest of the pot for Social Security and Medicare. Employers match the same 6.2% tax for Social Security and 1.45% for Medicare that employees pay, up to the annual income limit.

For 2020, the maximum income for payroll taxes is $137,700, and for 2021, it’s $142,800. For any income above that threshold, payroll taxes are not required.

Deducting bonuses as a business expense

All payments made to employees are tax-deductible business expenses. Payroll taxes are also deductible, which lowers the total business income for tax purposes. If you use Square Payroll, you can access your tax forms directly in your dashboard.

Sole proprietorships, partnerships, and LLCs are generally not able to deduct salaries or bonuses. That’s because these are considered pass-through entities where the business’s taxes are filed and paid with the owner’s taxes. Salary-related deductions are only available to business entities that file their own annual tax return, like C corporations.

Don’t let bonus taxation overwhelm your business

Bonus season can be a meaningful time, since it allows you to appreciate people for all their hard work. Pay attention to the tax impact, plan ahead, and don’t let the math of paying bonuses add too much stress to your plate.