Get Your Party Hats on: The Tax Magic Behind Giving Gifts to Employees and Contractors

It’s that time of the year when we give gifts to employees and contractors, thanking them for their hard work during the year. It just feels good when you are able to give someone a gift you know they want and appreciate.

Sounds great, but are there tax implications associated with giving gifts? If so, how do you handle this in your books so they sync up to your tax return, and how can you optimize your payroll program—whether that’s QuickBooks Online Payroll or something else—in the best way possible? 

Here’s a summary of what you need to know.

When Gifts are Taxable

Is your $49 Sam’s Club food basket as taxable as a $500 cash bonus?

The number one rule to remember is that gifts to employees—whether it’s at holiday time, for their birthday, or another occasion such as a work anniversary—is that gifts are taxable unless they cost less than $100 and are given occasionally.

According to the IRS, these gifts fall under “de minimis fringe benefits” (check out Certum’s video on de minimis for fixed assets) and include the following, for example:

·      One-time tickets to entertainment and sporting events.

·      Books, music, or even flowers given for condolences.

·      Holiday gifts with a lower fair market value ($100 or less).

 On the flip side, if you’re giving cash, those gifts are taxable. These include gift cards, cash (of course), memberships to clubs, and even vacations that are awarded for service.

The Bonus Tax Rate 

If you’re undecided whether to give your employees money or a physical gift they can unwrap, it seems almost 40 percent of employees prefer a cash bonus, according to a survey conducted by the Society for Human Resource Management.

The IRS says bonuses are considered “supplemental wages.” These include payments made to employees outside of their regular wages, including overtime, bonuses, commissions, accumulated sick pay, severance pay, and more.

In some circumstances, the IRS requires employers to withhold federal income taxes from supplemental wages at a higher rate than they would withhold from normal wages. That withholding rate depends on how much the employee earns. However, if you award a bonus of over $1 million—not a likely scenario for most of us—the bonus must be withheld at the highest taxable bracket, or 37 percent.

According to Hourly.com, for anything $1 million or less, there are three ways methods to figure this: 

1.     Employee Form W-4: Use this method if supplemental wages are paid with regular wages and not identified separately on the employee’s pay stub. This method usually makes sense for smaller bonuses and overtime pay because they typically don’t move the employee into a higher tax bracket. Example: If you’re giving an employee a $500 bonus along with their $2,000 of regular wages, the normal withhold tax rate of 10 percent applies, so you would withhold $250 from their $2,500 paycheck.

2.     Flat Rate Method: Also known as the “flat percentage method,” using this requires you to withhold income tax at a flat 22 percent. No other percentage is allowed if you use the flat rate method, but you can only use it if you withheld tax from the employee’s wages in the current or prior year. Example: The employee receives the same $500 bonus. You would withhold $110 from their bonus ($500 x 22 percent), plus the regular withholdings from their normal paycheck.

3.     Aggregate Method: This is the most complicated of the three methods, but you are required to use it if you haven’t withheld taxes from the employee’s pay before you award the bonus. For example, if your employee claims a high level of adjustments or an exemption from income tax withholding on their W-4. We won’t go into the details of how this is configured because it’s more likely you’ll figure the tax rate at either #1 or #2 above.

In addition to federal income tax, you also to withhold Social Security and Medicare Taxes, any applicable state or local taxes, and federal and state unemployment taxes.

Employee Bonus Pay: Business Expense

Awarding bonuses is good for you—the business—as well. You can claim a tax deduction for the salary, wages, commissions, bonuses, and other compensation paid to employees.

IRS Publication 535 provides the detail, but the largest concerns are the year you claim the deduction, and whether you use the cash or accrual method when filing your tax return.

·      Cash Method: Deduct bonus payments and other employee compensation in the year they’re actually paid to the employees.

·      Accrual Method: You may be able to deduct accrued bonuses; you’ve agreed to pay a bonus, but don’t actually pay it until the following year. To be deductible, the bonus amount must have been determined by the end of the year, paid to a non-related employee, and paid to the employee within 2½ months of year-end (March 15 for a calendar-year company).

Giving Gifts to Contractors

Of course, you can also give gifts to your contractors who receive a 1099 at the end of the year.

A few pointers:

·      If a bonus structure is built into their contractor agreement, that bonus is legally binding. These types of bonuses occur when a project is delivered prior to a deadline or when they meet calendar project-based goals, for example, and the bonus is reflected on the contractor’s 1099-NEC if they were paid more than $600 with their income and bonuses combined.

·      These cash bonuses are considered supplemental income and taxed at the flat withholding rate of 22 percent, instead of the usual marginal tax rate.

·      There are two ways to configure the tax withholding: the percentage method and the aggregate method. Details can be found in Circular E, Employer’s Tax Guide.

·      If you want to give a contractor a non-cash gift, it follows the same thinking as a non-cash gift for employees. As long as the gift is under $100, the contractor is not taxed for the value.

Let’s “Wrap” it Up

Our natural inclination is to award employees—and in many cases, contractors as well—gifts for a job well done, especially at the holidays. It feels good and shows your benevolent side … but don’t ignore the tax implications of giving gifts.

 If you need help with any of these tax rules and how gifts should be reflected in your books, and how to set up your payroll for gifts, contact us today; we’re here to help.

While they may seem somewhat complex, they all boil down to one thing: Were your employees and contractors naughty or nice?

Happy Holidays Everyone!