With the holidays and calendar year end approaching soon, many organizations will be taking time to evaluate their performance in 2015, and consequently, the performance of their staff. It’s also the time of year when many supervisors consider awarding bonus compensation or gifts to their employees to reward them for excellent performance and achievement of individual and team goals.
And while it’s nice to be able to provide this type of incentive to employees, those of us in the finance and human resource capacity are sometimes left feeling perplexed about what level of compensation or type of gift is appropriate to recommend (particularly in the nonprofit environment), and what the related tax requirements are for these types of transactions. If you do decide to issue bonuses or gifts to your employees this year, we highly recommend that you take appropriate precautions to ensure that you are in compliance with IRS guidelines.
Incentive based compensation, including bonuses are heavily scrutinized in nonprofit organizations to ensure no prohibited private benefit results. You can read more about this on the IRS website at www.irs.gov, but here are the general guidelines pertaining bonuses for nonprofit employees:
- The organization must have a real and discernible business purpose for issuing bonuses to its employees (i.e. incentivizing efficiencies and quality of service, encouraging cost containment). Bonuses cannot just be a means of distributing excess profits to employees. Additionally, bonuses should be based on objective standards of judging performance that are linked to the agency’s accomplishment of its exempt purpose.
- Bonuses should be determined and approved by an independent committee of the Board of Directors to demonstrate an arms-length relationship between the organization and the employees who will receive the compensation.
- The organization’s bonus plan should not compromise the organization’s ability to meet its programmatic expenses. In other words, bonus compensation should only be considered after all of the organization’s program related expenses have been covered for the year.
- Total compensation provided to employees over the course of a year (including bonuses) must be reasonable (i.e. equal to compensation that would ordinarily be paid for similar services by a similar enterprise for similar services).
- Your organization should specify that bonuses are discretionary and may be canceled at any time, to avoid any misunderstandings with staff in future periods, and to protect the financial health of the organization in years when excess profits are not available to be used as bonuses.
- If you are considering linking bonuses or any other compensation earned by employees (including regular salaries) to the revenue of your organization, you should consult a tax lawyer or your outside accountant, as these types of arrangements tend to require additional planning.
Taxation of Employee Bonuses
With regard to the taxation of employee bonuses, you should always consult with your payroll provider for the specific treatment of bonus compensation, but generally, employers can choose between two methods of withholding federal taxes from bonus or supplemental income when it is given to the employee in a check or direct deposit separate from regular income:
- Option 1. The employer may withhold a flat 25% for federal income taxes from the bonus payment, which is separated in the payroll from regular income.
- Option 2. The employer may add the bonus payment to the most recent regular income payment, determine the standard withholding based on tax tables and the sum of the two payments, subtract the amount already withheld from the most recent regular income payment, and withhold the rest from the bonus.
- A third option is for employers who choose to combine bonus compensation with regular compensation in one payment, check or direct deposit, without any differentiation between the two types of income.
- Option 3. The employer may base withholding on the sum of the bonus and regular pay using the standard withholding tables.
Regardless of the method the employer chooses, bonus income and regular income are grouped together when you file your taxes. The IRS will refund any overpayment and will collect any underpayment.
NFP Partners Nonprofit Finance & Accounting Consultant