Year-End Bonuses: Navigating Tax Implications for Employers and Employees
The holidays are often referred to as "the most wonderful time of year" — and, for some people, that's partly due to their year-end bonuses. While bonuses are an important part of rewarding employee performance and enhancing retention, they also can raise a variety of tax issues for both employers and employees. Here's what you need to know if you give or receive a bonus.
For the Employer: Deducting Bonuses Paid to Employees: Employers generally can deduct the cost of bonuses paid to employees before year-end, assuming they represent compensation for services rather than a gift. Tax regulations may complicate matters for bonuses paid after year-end, though. For employers that use cash-method accounting, it's simple — they can't deduct a bonus paid in 2024 on their 2023 tax returns. However, accrual-method businesses may have some breathing room. Under the 2½-month rule, those businesses can deduct a bonus paid for performance in one year if the employee receives it within 2½ months after year-end. After that time, the IRS presumes the bonus is deferred compensation, which isn't deductible in the year earned but only in the year it was actually or constructively paid. The 2½-month rule applies only to non-related employees. If the employee is the employer's spouse, child, sibling, parent, or grandparent, the business must deduct the bonus in the year the recipient reports it as income, which is most likely the year it's paid out.
For the Employee:
As an employee, you generally must report a bonus as income in the year you receive it, regardless of its form (for example, cash or cryptocurrency). It's irrelevant when you deposit it because, in the eyes of the IRS, it's your income as soon as it's available. On the other hand, if you receive a bonus after the New Year in recognition of your 2023 performance, it's taxable for 2024, not 2023.
Could a substantial bonus push you into a higher tax bracket? This may be an unavoidable side effect of a significant payout. Still, under our marginal tax system, the higher rate will apply only to your taxable income that exceeds the relevant threshold. For example, if you end up in the 32% tax bracket in 2023, the 32% rate applies only to your taxable income over $182,100, not your entire taxable income.
What can you do to reduce your tax liability from a substantial bonus? There are several options. For example, you could invest your bonus in your 401(k) or health savings account (HSA). You also could increase itemized deductions, if you claim them, by taking steps such as donating to charity. But pay close attention to the relevant deadlines for such tax-planning moves to apply for 2023. If you expect less taxable income next year (for example, because you plan on retiring), consider asking your employer to defer the bonus into 2024 so you'll pay a lower tax rate.
Plan! Most taxpayers know that good intentions don't cut it with the IRS. We can help you cover your bases regarding the tax issues related to year-end bonuses — whether you're an employer or an employee. Consult a Reynolds + Rowella advisor for personalized advice to maximize your year-end bonuses and navigate the complex tax landscape.
Reynolds + Rowella is a regional accounting and consulting firm known for a team approach to financial problem solving. As Certified Public Accountants, our partners foster a personal touch with our clients. As members of DFK International/USA, an association of accountants and advisors, our professional network is international, yet many of our clients have known us for years through the local communities we serve. Our mission is to operate as a financial services firm of outstanding quality. Our efforts are directed at serving our clients in the most efficient and responsive manner possible, delivering services that exceed the expectations of those we serve. The firm has offices at 90 Grove St., Ridgefield, Conn., and 51 Locust Ave., New Canaan, Conn. For more information, please contact Elizabeth Bresnan at 203.438.0161 or email.
