With the end of 2017 fast approaching, companies may be looking at paying their employees year-end bonuses. While these types of supplemental payments are likely welcomed by employees, just how much of that extra “jingle” they get to keep is often a question. Supplemental payments frequently raise issues related to taxation. This article compiles and clarifies guidance issued by the Internal Revenue Service (IRS) related to supplemental payments and when and how they are taxed.
What Are Supplemental Payments?
Supplemental payments to employees are in addition to, but are not, wages. Common examples are:
- Severance payments
- Awards and prizes
- Payments for non-deductible moving expenses
- Gift cards
- Employee loans
This list is not all-inclusive but comprises some of the more common supplemental payments that employers provide. Each of the items on this list, apart from some employee loans which will be discussed later, are taxable to the employee and must be reported as wages on his or her W2. One thing that an employer should note is that gift cards are always taxable to the employee no matter the balance – gift cards are never de minimis or excludable from wages.
How Much Federal Income Tax Should Be Withheld from Supplemental Payments?
Often the employer will be clear that a supplemental payment, such as a bonus, is taxable to the employee, but there can be confusion about the federal withholding rules related to the supplemental payments. There are only a few options for withholding, which are outlined below.
- Withhold at a flat 25% rate (no other flat rate is allowed).
- Withhold at the applicable rate using the standard withholding tables.
- Aggregate with regular wages paid at the same time and withhold at the applicable rate for the aggregate amount from the standard withholding tables.
- Do not withhold if the employee was totally exempt from income tax in the prior year and asserts that he or she will also be fully exempt from income tax in the current year.
The above apply to payments made to employees whose total annual compensation is below $1 million. The IRS rules state that withholding on supplemental payments to an employee whose annual compensation exceeds $1 million is a flat rate of 39.6%, regardless of the employee’s actual withholding rate on regular wages.
What Is the Proper Treatment for Loans to Employees?
An employer may make a loan to an employee for various reasons and with various terms. Depending on the nature of the loan, either the loan balance or the interest may be taxable to the employee. Often an employer thinks of a loan as a nontaxable event, so it is important for each loan to be considered carefully so that the company does not inadvertently run afoul of tax law.
If a loan is structured at a below-market interest rate, then the difference between the lower stated interest rate and the current applicable federal rate (AFR) is taxable to the employee. The tax rules do provide some relief to employees if the balance of the loan, without regard to interest at all times the loan is outstanding, does not exceed $10,000. Therefore, only large employee loans would be subject to the provision and require an interest calculation to determine the taxable portion.
In other cases, employers will provide employees what they call “sign-on bonuses,” which are actually employee loans. The employer will promise an employee a large amount up front, for example $24,000. The employer does not withhold federal income taxes or payroll taxes on this amount and promises the employee that this loan will be ratably forgiven over 2 years, or 24 months, of service to the employer. In situations such as these, the forgiven portion of the loan is includable in the employee’s wages as time progresses. In this example, if we assume that the employee is paid monthly, then $1,000 ($24,000/24 months) would be included in wages on each monthly pay period for the life of the loan. Additionally, if the terms of the sign-on bonus did not include a stated interest rate, then the imputed interest at the AFR would also be included in the employee’s wages.
In Conclusion – Each Situation Is Unique
The tax law surrounding supplemental payments to employees is not terribly complex, but what is more difficult to navigate is your unique situation. Which rate of withholding is the most appropriate given your own fact pattern? How should you differentiate between a true sign-on bonus and an employee loan, if only part of it is to be forgiven? Gift cards are always taxable – but how do you value a gift card that your company did not actually purchase? Questions abound when navigating the ins and outs of supplemental payments to your employees.
If you have any questions about supplemental employee payments, or would like to request a speaker on this topic for your organization or event, contact one of our PYA executives below at (800) 270-9629.