How To Deduct Employee Gifts, Awards, and Bonuses

When are gifts, awards, and bonuses taxable?

Employees chatting in the office
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Many employers give gifts or bonuses to their employees on an annual basis, whether it's during the holidays or on the employee's work anniversary. But before you give out those awards, bonuses, or gifts, consider the tax implications for your business and for the employees. You may be able to deduct them from your business taxes, but you'll need to know what issues could arise first.

Key Takeaways

  • Most gifts, awards, or bonuses are taxable to employees.
  • Businesses can usually write these expenses off because they're considered "ordinary and necessary."
  • Some small gifts are considered de minimis, and these aren't taxable to the employee.
  • Bonuses are not deductible for some small business owners because the IRS considers these owners to be self-employed.

Are These Gifts, Awards, or Bonuses Taxable to the Employees?

Most gifts to employees are taxable to them. If they are taxable income to the employee, you must withhold federal, state, and local income taxes and deduct the employee's share of FICA taxes (Social Security and Medicare taxes). You must also pay unemployment tax on these amounts.

You'll need to report taxable payments to employees on Form 941, the quarterly payroll tax report to the IRS, and Form W-2, the annual income tax report for employees and the Social Security Administration.

Are These Gifts, Awards, or Bonuses Deductible to Your Business?

Most of these payments are deductible as "ordinary and necessary" business expenses. These expenses must also be reasonable and they must be for "services performed." Some deductions have limits and qualifications.

Gifts to Employees and De Minimis Payments

Some small gifts are considered de minimis, and these aren't taxable to the employee.

These payments are called de minimis because they are a small cost and infrequent, "so small as to make accounting for it unreasonable and impractical." De minimis items include holiday gifts, occasional tickets for entertainment events, flowers, fruit, books, etc., under "special circumstances."

Cash payments or cash equivalent cards you give to employees are considered to be wages and these are always taxable to the employee. Gift certificates that can be redeemed by the employee for retail products also aren't de minimis and they are taxable to the employee.

Bonuses to Owners and Employees

Bonuses for employers/owners are a business expense and your business can deduct them under certain circumstances.

How and when you pay bonuses to business owners depends on the type of business:

  • S corporations can deduct bonuses for shareholders and owners, as long as they own their shares at the time the bonus is paid.
  • Corporations can deduct bonuses for corporate officers who are paid employees.

Bonuses are not deductible for some small business owners (sole proprietors, partners, and LLC owners) because the owners are considered by the IRS to be self-employed. The money these business owners pay themselves is considered a draw or distributive share, not a bonus.

Bonuses to employees are considered income and they are always taxable to the employee.

If you decide to give your employees a bonus, you should allow them to change their withholding (on Form W-4) for that paycheck, and change it back again for later paychecks. Many employees like to change their bonus check withholding to get more of the bonus. (See details below.)

Bonuses are considered additional pay for services and are deductible business expenses as long as they are a reasonable amount and they are tied to services by the employee. The bonuses can't be a gift.

Employee Awards and Business Tax Deductions

Taxable to Employees

Service and safety awards are not taxable to employees if they are limited. There are limits on service awards (not during the first five years, and not more often than every five years) and safety awards (not to more than 10% of employees). Awards over the limits are taxable to the employee.

Deductible to Your Business

You can deduct the cost of employee awards from your business taxes, for both cash or personal property (like a watch). This includes achievement, service, and safety awards. There are requirements and limits for deducting each of these types of awards.

See IRS Publication 535 Business Expenses for details on these requirements and limits.

Your business may take higher deductions on awards given as part of a qualified plan that fits IRS requirements. A qualified plan is a specific written plan or program that doesn't favor highly compensated employees. Highly compensated employees are those that are either a 5% owner or who received more than a specific amount, as defined by the IRS each year.

Supplemental Wages and Withholding

The IRS considers bonuses, gifts, and rewards in the category of supplemental wages. How you withhold from employees on supplemental wages depends on whether the payment is separate from regular wages (like a separate bonus check).

This withholding is for federal income tax only. In general, if the wages are paid in a regular paycheck, withholding is done on the whole paycheck in the normal way, including the supplemental part. If you pay the supplemental wages in a separate check, you can withhold a flat 22% or you can withhold at the normal rate you are currently using for that employee. (This is an oversimplification and there are many exceptions.) Please check IRS Publication 15 for more details.

Withholding and 'Grossing Up' Employee Cash Gifts or Bonuses

Employee gifts are usually small enough that you don't need to worry about employees wanting to change their withholding allowances. But for larger bonuses, you should give employees the option of changing their W-4 withholding deduction amount for that one paycheck.

You must allow employees to change their W-4 forms as often as they wish. This process requires two W-4 forms—one for the withholding on the bonus check and another to return to the employee's original withholding amount.

You can also 'gross up' a bonus check to allow an employee to get a higher amount after taxes. For example, if you give an employee a $1,000 bonus, by the time you take out taxes, the bonus check might be only $750. You can calculate a higher amount for the bonus so that the check shows the full $1,000. The employee is getting what looks like a higher bonus, but the amount is after taxes. Paycheckcity has a gross-up calculator you can use to help determine the net amount of a bonus check, allowing for payroll taxes.

Frequently Asked Questions (FAQs)

How do you give an employee a bonus without taxes?

Bonuses are considered taxable income and so the employee needs to pay taxes on that money. You can give an employee a bonus check separate from their usual paycheck or as part of their usual paycheck. Taxes will be taken out of both. To give your employee a bonus check at the full amount, gross up so that the after-tax amount (net pay) is worth the bonus amount you wanted to give to the employee.

How do you calculate an employee's bonus?

Different businesses calculate an employee's bonus differently. You can have a flat rate bonus, such as $500 per year, or a percentage of an employee's pay, such as 5% of their annual salary. You can also offer bonuses at the end of the year, at the employee's anniversary, or at another milestone.

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