Special analysis: How to tax and deduct bonuses

Business Management Daily writes: The IRS has confirmed that how you withhold income taxes from supplemental pay, such as bonuses—by using a flat withholding method or aggregating the supplemental pay with other wages—is entirely up to you, employees can’t specify a withholding method. The IRS has also concluded that bonuses paid to employees who must be on the payroll on the date of payment are deductible in the year paid, not in the year services are performed.

Income tax withholding

There are three possible income tax withholding methods that apply to supplemental pay, such as bonuses:

1. Mandatory flat rate withholding at 39.6% on supplemental pay exceeding $1 million
2. Optional flat rate withholding at 25% for supplemental pay not exceeding $1 million
3. Aggregating supplemental pay of less than $1 million with regular pay and withholding as if the total were a regular wage payment (also optional).

The IRS concluded in a General Information Letter that for the flat withholding methods, no other tax rates apply, so employees can’t request withholding at a higher or lower rate, or that an additional amount be withheld. However, for the aggregation method, employees can refile their Forms W-4 to claim a greater number of withholding allowances. Catch: The refiled W-4s also apply to future regular wages, unless employees refile again after receiving their supplemental pay, which the IRS said employees were free to do. (INFO 2012-0063)

PAYROLL PRACTICE TIP: The IRS’ analysis that employees can keep refiling their W-4s isn’t new, and it can play havoc with your payroll processing schedule. The IRS also reiterated that you have discretion regarding when to put refiled W-4s into effect. Under long-standing rules, you may put refiled W-4s into effect with the next wage payment or wait until the start of the first pay period ending on or after the 30th day from the date employees refile with you.

Deducting bonuses

When bonuses are deductible for businesses that use an accrual method of accounting can be tricky. Under the accrual method of accounting, you can take a deduction before you actually incur an expense, but only when all the events have occurred that establish the fact of the liability.

In Chief Counsel Advice, the IRS concluded that bonuses were deductible in the year paid because employees were required to be employed on the date bonuses were payable. Bonus money wasn’t reallocated among the remaining employees in the bonus pool if employees terminated before the bonus payment date; instead, the money reverted to the company. IRS: The fact of the liability wasn’t established because there was no fixed liability in the year services were performed. Rather, the liability became fixed only if the contingency was satisfied—that is, when employees were still employed on the payment date. (ILM 201246029)
PAYROLL PRACTICE TIP: One small tweak to this incentive pay plan would have changed the result: If forfeited amounts went back into the bonus pool and were split among the remaining participants, the fact of the liability would be established.