Employee Bonus on Sale of Company: Tax Rules

When a company is sold, it is common for certain employees to receive a bonus. This payment can reward individuals for contributions that led to the transaction or encourage them to remain with the company during the post-sale transition period. These bonuses are a form of compensation designed to align the interests of key staff with those of the company’s owners and the acquiring entity.

Common Types of Sale-Related Bonuses

A primary category of bonus is the transaction bonus, sometimes called a deal bonus. This is a one-time, lump-sum payment contingent upon the successful closing of the company’s sale. The purpose of a transaction bonus is to reward key employees for their direct efforts that facilitated the merger or acquisition, as these individuals often undertake an additional workload during the due diligence process.

The payment of a transaction bonus is tied directly to the completion of the deal. If the sale does not go through for any reason, the bonus is not paid, which creates an incentive for participants to work towards a successful closing. The size of the bonus pool can be structured as a percentage of the total deal value or as fixed dollar amounts determined by the board of directors.

Another incentive is the retention bonus, also known as a stay bonus. Unlike a transaction bonus that rewards past work, a retention bonus is forward-looking and paid to an employee for remaining with the newly acquired company for a specific period. The goal is to ensure business continuity for the buyer by securing the talent and institutional knowledge of essential personnel.

Retention bonuses are used when the acquiring company needs to prevent a loss of managers, engineers, or salespeople integral to ongoing operations. The payment terms are defined in a retention agreement, which specifies the length of time the employee must stay, often ranging from six months to two years. The bonus may be paid as a lump sum or in installments, and some agreements include provisions for payment if the employee is terminated without cause.

Forms of Bonus Compensation

The most common form of a sale-related bonus is a cash payment. This method is straightforward, providing the employee with immediate liquidity without the complexities of other compensation forms. The value is clear and not subject to market fluctuations or vesting schedules beyond the initial terms of the bonus agreement.

A company may also award bonuses in the form of stock or other equity in the acquiring company. This approach aligns the employee’s long-term financial interests with the success of the new entity. Receiving stock means the ultimate value of their bonus is tied to the company’s future performance, and these awards often come with vesting schedules requiring continued employment to gain full ownership.

In situations where granting actual stock is not feasible, such as in private companies, phantom stock or Stock Appreciation Rights (SARs) are used. These are cash-based awards where the payout is linked to the value of the company’s stock without granting any actual equity. An employee with phantom stock receives a cash payment at the time of the sale equivalent to the value of a certain number of shares, providing a direct financial reward tied to the deal’s success without diluting ownership.

Tax Consequences for the Employee

For the employee receiving a bonus related to a company sale, there are tax implications. The Internal Revenue Service (IRS) classifies these payments as supplemental wages, not as capital gains. This means the entire bonus amount is treated as ordinary income and is taxed at the employee’s regular income tax rate, which is higher than long-term capital gains rates.

Because these bonuses are considered wages, they are subject to mandatory tax withholding. Using the percentage method for federal income tax, the employer withholds a flat 22% from the bonus for supplemental wages up to $1 million. If an employee’s total supplemental wages for the year exceed $1 million, the amount over that threshold is subject to a 37% withholding rate.

Bonus payments are also subject to payroll taxes. This includes Social Security tax, applied up to an annual wage limit of $176,100 for 2025, and the 1.45% Medicare tax, which applies to all wages. Additionally, a 0.9% Additional Medicare Tax is withheld from employee wages that exceed $200,000 in a calendar year.

All bonus income and the associated taxes withheld will be reported on the employee’s Form W-2. The bonus amount is included with regular salary in Box 1 (Wages, tips, other compensation), and this combined figure is used to file annual tax returns. Employees should anticipate the tax liability and consider whether the standard withholding will be sufficient.

Employer Considerations and Special Rules

Bonuses paid to employees in connection with a sale are considered compensation and are therefore tax-deductible as a business expense. This deduction can be taken by either the selling company or the acquiring company, depending on which entity is legally responsible for making the payment according to the sale agreement. This deductibility helps offset the cost of these incentive programs.

An area of regulation involves the “golden parachute” rules, designed to discourage excessive compensation payments to certain individuals during a change of control. If a payment is deemed a “parachute payment,” it can lead to negative tax consequences for both the company and the recipient. The rules apply to “disqualified individuals,” a group that includes company officers, certain shareholders, and highly compensated individuals.

If the total payments contingent on the sale equal or exceed three times the individual’s “base amount” (their average annual compensation over the prior five years), the payments are classified as “excess parachute payments.” When this happens, the company loses its tax deduction for the excess portion of the payment. The disqualified individual is also hit with a 20% excise tax on the excess payment, in addition to their regular income and payroll taxes.

To navigate these rules and avoid disputes, companies should establish a formal, written bonus plan or agreement. This document should define the eligibility criteria, payment triggers such as the closing of the sale, and the amount and form of the bonus. A well-drafted plan provides clarity for all parties and creates an official record for tax and legal purposes.