Business success often hinges on attracting and retaining dedicated employees. Beyond offering competitive salaries and benefits, business owners can sweeten the pot with employee bonuses. This is a great way to reward employees who’ve helped your business grow – especially if you’re celebrating a profitable year.

Planning early so that you are able to offer your employees a decent bonus can help your business stand out from the pack. According to data from the Bureau of Labor Statistics (BLS), 12% of all U.S. workers have access to an end-of-year bonus.¹ In addition to helping you recruit new talent, showing your appreciation for the people who keep your company ticking makes them more likely to stick around.

If you’re a business owner looking to give your staff an extra incentive, it’s worth considering how employee bonuses will factor into your annual budget. Here are a few things to keep in mind as you prepare to spread the kind of joy around the workplace that can only be produced by freshly cut bonus checks.

Develop a transparent bonus program – and budget for it

Bonuses may enhance employee morale and satisfaction but if you’re planning to hand out supplemental checks, you’ll want to put in place an equitable and well-defined bonus policy. Having a transparent system in place can help you avoid tensions between employees who may size up their rewards against those of their coworkers.

There are several ways you could structure bonuses. You might consider giving all employees a similar bonus, such as a week’s worth of wages or a certain percentage of their salary. Alternatively, you could base bonuses on how long an employee has been working with the company or tie them to a performance metric. No matter how you calculate bonus payouts, making sure your employees understand the system can help you avoid any tension.²

As you decide on how much to pay your employees in bonuses, it’s critical to consider the impact on your overall budget. Remember that payroll taxes add to the total cost of giving bonuses. Also, anything you pay out will be above and beyond the employee’s regular salary and benefits, including any matching contributions to your company’s qualified retirement plan.³

The good news is that, unless your employees’ contracts specify the bonus they will receive, the decision on whether and how much to pay out remains up to you. This gives you some flexibility to reward employees without blowing up your budget, striking a balance between boosting morale and protecting your company’s financial health. With this in mind, it could be a good idea to use your company’s revenue projections to create a rough bonus budget at the start of the year, which can then be regularly adjusted based on several factors like actual performance, the performance of your employees and any employee turnover.

Consider the tax implications

For tax purposes, any bonuses you pay out will be treated as supplemental wages – a category that also includes perks like commissions, overtime pay and compensation for unused sick leave. Bonuses and other supplemental wages are subject to income tax withholding and Federal Insurance Contributions Act (FICA) payments.⁴

As an employer, your share of FICA for bonus payments remains the standard 7.65%. In other words, if you gave out a bonus of $1,000, you would be on the hook for paying $76.50 toward your employee’s Social Security and Medicare.⁵

When it comes to income tax withholding, you have a couple of options for treating bonus payouts. If you combine the supplemental payment with your employee’s regular wages – without specifying the amount in each category – you should use the same method of determining your withholding that you would apply for a typical pay period.⁶

However, if you pay the bonus separately or combine it with regular wages but break down the amount of each category, you could withhold at a flat rate, which is set at 22% in 2024, or use the aggregate method.⁷ If you pay an individual employee supplemental wages of more than $1 million in a calendar year, the excess amount is subject to a mandatory supplemental flat rate of 37% without regard to the employee’s Form W-4.⁸

Determine when to take deductions

Paying out bonuses around the holiday season or as a year-end incentive can add some complexities to your company’s end-of-year tax accounting. This is because many employers opt to declare bonuses before December 31 but pay them out in the new year.

If you announced bonuses last year but pay them out this year, your company will need to figure out if the payments are deductible in the tax year that your employee earned them or the tax year when you make the actual payment. Generally, bonuses are deductible in the year paid, but in some cases, they may be deducted in the prior year.

If you run a calendar-year business and use accrual-based accounting – and have a properly designed bonus pool and procedures – bonuses may be deductible in the year that they are earned as long as you complete the payout by March 15 of the following year.⁹ However, bonuses paid to owner-employees are not deductible until they are actually paid, so business owners should pay close attention to the tax impact before issuing themselves a generous bonus check.¹⁰

Bottom line

A workforce that feels appreciated and valued is often a key ingredient of a successful business. Offering your employees bonuses may go a long way toward boosting their satisfaction.

As you determine a supplemental incentive program that makes sense for your company, you’ll want to ensure that bonuses are fair and transparent. You should also factor in the total cost of paying bonuses, including payroll taxes, and determine the tax year in which the payouts are deductible. For this reason, planning early – even as early as the start of a new earnings year – can ensure you can reward your employees well without impacting the financial health of your business.

Trusted accounting and tax professionals could be important resources in helping you reward your employees without jeopardizing your company’s profitability or growth potential.