Can a Business Write Off Employee Bonuses?

Employee bonuses are an additional form of compensation, often awarded for strong performance or as part of a structured compensation plan. These payments serve as a valuable tool for businesses to incentivize and reward their workforce. Understanding their tax implications, specifically their deductibility as business expenses, is crucial. Generally, employee bonuses are tax-deductible for a business, provided they meet specific criteria established by tax authorities. This deductibility ensures bonuses are legitimate compensation, not disguised distributions.

General Principles of Business Expense Deductibility

Businesses can deduct expenses considered “ordinary and necessary” for operations. An ordinary expense is one that is common and accepted in a particular industry or trade. It is typical for similar businesses under similar circumstances, not necessarily habitual or frequent. Salaries and wages are examples of ordinary business expenses.

A necessary expense is helpful and appropriate for the business. It contributes to the development or maintenance of the business, but does not need to be indispensable.

Beyond ordinary and necessary, expenses must be “reasonable in amount.” This ensures payments are not extravagant or excessive for services performed. The IRS scrutinizes if the amount is comparable to what similar businesses pay for like services. Unreasonable portions may be disallowed.

These principles apply to all business expenses, including employee compensation like salaries, wages, and bonuses. The payment must genuinely represent compensation for services rendered, not a gift or profit distribution.

Specific Considerations for Employee Bonuses

Timing of Payment

Bonus payment timing significantly impacts deductibility, depending on the business’s accounting method. Cash-basis businesses deduct bonuses only in the tax year they are paid. For example, a bonus earned in December but paid in January is deductible in the January payment year.

Accrual-basis taxpayers may deduct bonuses in the year earned, even if paid in the subsequent tax year, if specific conditions are met. The “2 ½ month rule” allows deduction in the earlier year if the bonus is paid within 2 ½ months after the tax year-end. Payments after this window are deferred compensation, deductible only when paid and included in employee income.

For the 2 ½ month rule, bonus liability must be fixed and determinable by year-end. This requires all events establishing liability to have occurred, and the amount to be ascertainable. If an employee must be employed on the payment date and forfeited amounts revert to the company, the liability may not be fixed. However, if forfeited bonuses are reallocated within a bonus pool, the aggregate amount can be fixed, allowing deduction.

Form of Bonus

Employee bonuses can be paid in various forms. Cash bonuses are straightforward and deductible if they meet the ordinary, necessary, and reasonable criteria, considered additional compensation for services.

Non-cash bonuses, like property, gift cards, or services, also qualify as deductible expenses. The deductible amount for these items is their fair market value. For instance, if a business awards company stock as a bonus, its fair market value at transfer is deductible.

Certain de minimis fringe benefits, like small non-monetary gifts (e.g., a holiday ham), may not be taxable income to the employee. If a non-cash bonus is considered taxable income to the employee, its value must be included in the employee’s wages for tax purposes.

Bonuses to Owners and Related Parties

Bonuses paid to owner-employees (e.g., S-corporation shareholders, partners, family members) receive heightened IRS scrutiny. The concern is that these payments may be disguised dividends or profit distributions, not legitimate compensation. The “reasonableness” test is particularly emphasized.

The IRS assesses if compensation to an owner or related party is comparable to what an unrelated individual would receive for similar services. Factors considered include:
The individual’s qualifications
The nature and extent of their work
The size and complexity of the business
Compensation paid to employees in comparable businesses
If a bonus is unreasonable, the excess may be reclassified, resulting in disallowed deductions. Special rules apply to accrued bonuses for related parties; an accrual-basis business cannot deduct an accrued bonus payable to a cash-basis controlling shareholder until the shareholder recognizes the income.

Accrued Bonuses

Accrual-basis taxpayers can deduct bonuses when the liability is incurred, even if payment occurs later. This is governed by the “all-events test,” requiring that all events establishing liability have occurred, the amount is determinable, and economic performance has occurred. For employee bonuses, economic performance occurs as the employee performs the services that earn the bonus.

The challenge for accrued bonuses lies in satisfying the first two conditions, especially if contingent on future events like continued employment. If the employer retains discretion to modify or cancel the bonus, or if a forfeited bonus reverts to the employer, the liability may not be fixed at year-end. To ensure deductibility, bonus plans often require forfeited amounts to be reallocated to other employees, establishing a fixed aggregate liability.

Performance-Based vs. Discretionary Bonuses

The nature of a bonus, whether performance-based or discretionary, can influence its deductibility, especially for larger corporations. Performance-based bonuses are tied to specific, measurable metrics like sales targets. Discretionary bonuses are given at the employer’s discretion, often for holidays or exceptional contributions. Both are deductible if they meet the ordinary, necessary, and reasonable criteria.

For large publicly traded companies, specific rules limit the deductibility of compensation, including bonuses, paid to certain top executives. Section 162(m) of the Internal Revenue Code limits compensation deductibility to $1 million per year for the CEO and the three other highest-compensated officers (excluding the CFO). An exception for performance-based compensation was largely eliminated by tax law changes. This means performance-based bonuses for these executives above the $1 million threshold are not deductible.

Employer Withholding and Reporting Requirements

Employers must fulfill specific withholding and reporting obligations for employee bonuses. The IRS categorizes bonuses as “supplemental wages,” subject to federal income tax withholding, Social Security, and Medicare taxes.

Income Tax Withholding

Employers have two methods for calculating federal income tax withholding on bonuses. The “percentage method” (or flat rate method) applies a flat 22% rate to bonuses up to $1 million. For amounts exceeding $1 million within a calendar year, a higher flat rate of 37% applies to the excess. This method is used for stand-alone bonus checks.

The “aggregate method” combines the bonus with regular wages for a pay period, calculating withholding on the total. The employer uses the employee’s Form W-4 information to determine appropriate withholding. This method is used if the bonus is included with a regular paycheck. Regardless of the method, the bonus is ultimately taxed at the employee’s marginal tax rate when they file their annual tax return.

Social Security and Medicare Taxes (FICA)

Bonuses are fully subject to Federal Insurance Contributions Act (FICA) taxes. The Social Security tax rate is 6.2% for both employer and employee, applied to wages up to an annual wage base limit ($176,100 for 2025). The Medicare tax rate is 1.45% for both, applied to all wages without a limit. A combined 7.65% is withheld from the employee’s bonus for FICA, with the employer remitting a matching amount.

Federal Unemployment Tax Act (FUTA)

Bonuses are also subject to Federal Unemployment Tax Act (FUTA) taxes. FUTA is an employer-only tax. The FUTA tax rate for 2025 is 6.0% on the first $7,000 of each employee’s gross wages. This rate can be reduced significantly by credits for contributions to state unemployment programs, resulting in a net federal rate of 0.6% in most states.

Form W-2 Reporting

Employers must accurately report bonuses on the employee’s Form W-2. The bonus amount is included in Box 1 (Wages, tips, other compensation), Box 3 (Social Security wages), and Box 5 (Medicare wages) of the Form W-2, along with regular wages. Bonuses are ultimately reported as part of the employee’s total annual taxable income.

State and Local Taxes

In addition to federal obligations, bonuses may be subject to state and local income taxes, and state unemployment taxes. Some states may have a flat tax rate for bonuses, while others tax them at the same progressive rates as regular income. Employers must comply with the specific withholding and reporting requirements of each state and locality where their employees work.