72: Bonus Compensation Tax and Overtime Compliance

What’s the right way to withhold federal income tax?
Are the wages included in the overtime pay rate calculation?
And what about pay discrimination?
Listen to this Episode

The people who write tax code are masters of confusion. I often wonder if they do it on purpose or if they really are idiots. 

Once you’ve decide the why, who, what, when, and how to bonus your employees you’ll need to look at the compliance aspects of your plan.

What’s the right way to withhold federal income tax?

Are the wages included in the overtime pay rate calculation?

And what about pay discrimination?

Federal tax withholding rate:

How bonus compensation is taxed from a federal income tax withholding standpoint depends on weather or not the earnings are consider regular wages or supplemental wages.

And how you withhold the tax on supplemental wages depends on whether the payment is identified as a separate payment from regular wages.

The IRS regulations don’t give a comprehensive definition of “supplemental wages,” but they do mention bonuses, commissions, and overtime pay.

In June of 2008, the IRS kindly issued revenue rule 2008-29 to help explain their twisted thinking.

Why, again, are employers made to be tax collectors? Oh, yeah, I remember, to accelerate tax revenue, hide the true amount of tax being paid and make it easier to collect.

Here is what they say:

Supplemental wages are all wages you pay that are not regular wages. Clear as mud… yes, thank you IRS!

Maybe it’s easier to define regular wages, and then everything else, by default, is supplemental.

Regular wages are amounts paid at a regular rate for either hourly, daily or similar period FOR THE CURRENT payroll period – Or, amounts that are paid at a PREDETERMINED FIXED DETERMINABLE amount FOR THE CURRENT payroll period.

So for example, if you had a bonus plan that paid your hourly employees .25 cents an hour for each day they showed up on time for their shift, and you paid the bonus each pay period, that would be regular wages.

OR

Let’s say you are a transportation company and you pay your employees a quarterly bonus equal to 10% of their earnings for the quarter if there were no accidents during the quarter. That’s not regular wages and therefore it’s supplemental wages.

So now that we’ve solved that mystery. How are supplemental wages taxed?

There are three options but only two generally apply.

  1. The first option is to add the entire amount to the regular wages, and withhold the federal income tax as you normally would. For this to apply, you pay the wages as one earning type and don’t separately identify them on the check stub.
  2. The second option is to withhold a flat 25% of the supplemental wages. You do this where you have either paid the supplemental wages separately, or on the same check, but you identified the amount of each type on the check stub.
  3. The third method applies if you either pay the regular and supplemental wages separately or together if you identify them on the check stub but you want to tax them like you do in the first method but still pay them separately. Or, if you didn’t withhold income tax from their regular wages in the current or immediately preceding year.

The idiots who write tax code are masters of confusion. I often wonder if they do it on purpose or if they really are idiots.

But what about gift cards, gift baskets, event tickets, meals or a holiday turkey or ham…and the like? Are those taxed?

Cash or cash equivalent items like gift cards and gift certificates…. those are supplemental wages and should be taxed as supplemental wages.

But non-cash bonuses or awards like gift baskets, event tickets and food, aren’t taxed if they nominal value and are provided infrequently. These items are called de minims fringe benefits, and they are not income for payroll tax purposes.

Overtime pay rate calculation:

The next compliance issue is overtime, and weather or not the bonus is included in the regular rate of pay, which is the basis for the overtime rate.

For this we have to determine if the bonus is discretionary or non-discretionary.  Only payments that are non-discretionary are included in the regular rate calculation. This is regulated by the Fair Labor Standards Act, or FLSA. The Department of Labor enforces the FLSA and they point out that few bonuses are discretionary under the Act.

A discretionary bonus is a payment that’s made where it’s completely up to you to decide if, when and how much. Whereas a non-discretionary bonus is a payment that you’re obligated to make because it is part of a contract, policy or promise.

Things like attendance awards and production bonuses are typically non-discretionary because they are based on specific achievements and paid a pre-determined rates. You’ve told your employees about them and it’s easy to track and know when the bonus has been earned.

Non-discretionary bonus payments are considered regular wages for overtime compliance and they have to be added to your employees earnings and divided by the total number of hours worked each week. That gives you the regular rate of pay and any hours worked in excess of 40 per week are paid at 1.5 times the regular rate of pay.

Check out episodes 17, 18 and 19 for more information about overtime.

This can become difficult to manage if the bonus was earned over a long period. Once it is paid, you have to allocate the amount over the workweeks in the earnings period. If your employee worked overtime during that period then you’ll have to recalculate the amount earned and pay any past-due balance.

Here’s an example from the DOL.

In an effort to attract more nursing personnel, a skilled nursing facility’s nursing department gives hourly paid LPNs and RNs a $2,000 bonus after being employed six months. Does this bonus have to be included in the regular rate? If so, how does it need to be calculated?

Yes. The retention bonus must be included in the regular rate calculation in overtime weeks covered by the bonus period. The retention bonus described above was earned over six months or 26 weeks. The weekly equivalent is $76.92 ($2,000 ÷ 26 weeks). If an employee works overtime during the 26 week period, the increase in the regular rate is calculated by dividing $76.92 by the total hours worked during the overtime week.

As for discrimination… all I’m going to say is be fair. Be aware of who you are giving bonuses to and make sure you aren’t favoring one group over another. You’ve always got to be aware of how the plan is perceived. If you are giving a bonus to employees of a specific department, make sure everyone in the department is included in the plan.

Make sure that any pay differentials are based on seniority, merit, quantity or quality of production, or a factor other than sex. These are known as “affirmative defenses” and it is your burden to prove that you applied them correctly.

Entitlement Mentality:

Be careful with recurring discretionary bonuses like holiday – if you pay it every year and and the amount is always the same or very similar then you’re creating an entitlement mentality and possibly creating a non-discretionary situation where you can be legally obligated to pay it. Adjusting the amount, type and timing can help keep the discretionary qualities alive.

About the author, Thomas

I have 20 of years insurance industry experience in C-level management, focusing on all aspects of workers compensation, risk management, loss control, employee benefits, HR, payroll and professional employer organization (“PEO”) operations. Currently, I am the owner and CEO of Humanly HR, and founder and host of SmallBiz Brainiac; a podcast providing employer intelligence to small business owners.

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