Overtime and Tax Consequences of Year-End Bonuses

For purposes of determining an employee’s “regular rate” to calculate overtime compensation, the key initial determination is whether a bonus can be categorized as discretionary or nondiscretionary. A discretionary bonus is excludable from an employee’s regular rate of pay, while a nondiscretionary bonus must be included in the regular rate.

A bonus is discretionary if the employer retains decision-making authority over both the fact and amount of the bonus—that is, not only how much to pay as a bonus, but more importantly, whether to pay the bonus at all. If a bonus payment is required under a contract, promise or policy that leads an employee to expect payment, it is not discretionary. A nonrecurring giveaway—like a Christmas goose, or its modern-day equivalent, a store gift card—is generally considered a discretionary bonus.

Likewise, an employer’s decision to pay a bonus in the form of two weeks’ salary to all employees, so long as not done pursuant to an established policy or promise, would be considered discretionary.

Production bonuses, sales incentives and attendance awards are all bonuses that are dependent on an employee’s hours worked or on the quality or quantity of the outcome of the employee’s work. They are readily calculable and considered to be nondiscretionary bonuses. They are not gifts to employees, but rather deemed to be akin to wages, earned through the employee’s service or his or her productivity or efficiency, and employers must include them in the employee’s regular rate for overtime purposes.

If the nondiscretionary bonus covers only one week or the single pay period in which it is paid, including it in the regular rate for purposes of calculating overtime is not difficult. In those circumstances, the amount of the bonus is merely added to the employee’s earnings and the total is divided by the total number of hours that the employee worked each week.

However, where the bonus payment is intended to cover an extended period (such as a quarter, a semi-annual period, or an annual period), the bonus payment must be apportioned back over the workweeks of the period in which it was earned, and the employee must be paid an additional amount of overtime compensation for each workweek that he or she worked overtime during the period allocable to the bonus. Employers have several options for calculating the additional overtime, and they should consult with counsel to determine which approach is appropriate for them.

Bonus Taxability

Internal Revenue Service regulations classify “non-cash” items that (1) have nominal value, and (2) are provided infrequently, as “de minimis” fringe benefits excludable from an employee’s earnings for payroll tax purposes. Such items include occasional tickets to entertainment events, occasional meals, occasional parties and picnics, and holiday turkeys and hams. In contrast, the payment of bonuses in the form of cash and cash equivalents (e.g., gift cards or gift certificates), are always taxable regardless of their value.

Like employee wages, not only is the employee taxed on the cash bonus payment, but the employer is as well—in having to pay its share of payroll taxes. Employers should be mindful that recurring gifts, regardless of the amount, do not qualify for de minimis status and are included in wages. So, if the employer is providing holiday gifts all year long (e.g., for St. Patrick’s Day, Memorial Day, Independence Day, Labor Day, Columbus Day, or Flag Day), this year’s holiday turkey may very well be reportable.

A previously posted Ogletree Deakins article, "Are Holiday Gifts, Prizes or Parties Taxable Wages?," reviews the taxation issues involved with holiday gifts in detail.

Under many state laws, if a bonus is readily calculable either at or near year’s end, the employee is entitled to it, regardless of whether he or she is still on the employer’s payroll on the payout date. Thus, when a bonus program is based on objective criteria, such as company profitability or employees’ achievement of performance or productivity goals, it becomes a unilateral promise by the employer to pay the bonus to employees once specific results are achieved.

Most state courts and administrative agencies will enforce the terms of this type of nondiscretionary bonus program but disregard those provisions that condition payment of the bonus on an employee’s active employment on the date that the bonus is paid. Because state wage payment laws and contract laws vary from state to state, employers should consult with counsel to determine whether they must consider any state-specific issues when implementing a nondiscretionary bonus plan.

Bonuses Aren't Entitlements

A key step employers can take to counteract the mentality that employees are entitled to bonuses is to make bonus determinations discretionary. Employers should consider determining and announcing bonuses after the close of the performance period to forestall any expectation of a year-end bonus payment. Employees who are discharged or resign prior to the payment of a discretionary bonus generally have no legal entitlement to a bonus payment.

Note that when an employer regularly provides year-end “discretionary” bonuses and the amount of the bonus varies little from year to year, the employer may be inadvertently creating a nondiscretionary bonus plan that may be legally construed as an implied promise to pay bonuses in future years. To avoid this type of unintended consequence, management may wish to exercise its discretion by varying the timing and amounts of bonuses from year to year.

Year-end bonuses do much to cultivate employee loyalty, build morale and stimulate productivity, all of which are good for business. Employers must simply be mindful of creating entitlements versus rewards and of the additional costs that an otherwise gratuitous payment can have.

Tracey Truesdale is of counsel in the Chicago office of Ogletree Deakins. A longer version of this article originally was posted on Ogletree Deakins' Wage & Hour blog in December 2013. © 2013 Ogletree Deakins. All rights reserved. Republished with permission.

Related SHRM Articles:

• Are Holiday Gifts, Prizes or Parties Taxable Wages?, SHRM Online Compensation, December 2013
• How to Calculate Bonuses into a Regular Rate of Pay for Overtime Purposes , SHRM Templates & Samples, September 2013
• How to Calculate Overtime Rates for Shift Differentials, SHRM Templates & Samples, September 2013
• Beyond Pay for Performance: Countering the 'Pay Entitlement' Mindset, SHRM Online Compensation, August 2009

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