Taxation of a Forfeitable Bonus and Its Repayment

A forfeitable bonus is compensation given to an employee that is contingent upon meeting predetermined conditions. Employers use these bonuses as a retention incentive, sometimes called a “golden handcuff,” to encourage employee loyalty and continued service. For instance, a company might offer a forfeitable bonus to personnel to ensure they remain through a transitional period like a merger. The employee only gains an unconditional right to the bonus after fulfilling the requirements in their agreement, which helps employers increase stability and protect against the loss of talent.

Common Forfeiture Conditions

A prevalent condition for the forfeiture of a bonus is a time-based vesting schedule. One common approach is “cliff vesting,” where the employee becomes 100% vested in the bonus on a single future date. For example, an employee might be granted a bonus that fully vests only after completing three full years of service from the grant date.

Another time-based method is “graded vesting,” which allows an employee to secure portions of the bonus incrementally over time. A graded schedule might vest 25% of the bonus each year over a four-year period. Under this arrangement, if an employee leaves after two years, they would be entitled to 50% of the total bonus amount, forfeiting the remaining half.

Forfeiture can also be tied to performance-based conditions, linking the bonus payment to the achievement of specific, measurable goals. These goals can be individual, such as meeting a sales target, or they can be based on broader company performance, like achieving a certain level of profitability. If these predetermined metrics are not met within the specified timeframe, the employee forfeits the right to the bonus.

The circumstances of an employee’s departure also play a role in forfeiture. Bonus agreements stipulate that voluntary resignation before the vesting date results in the complete forfeiture of the bonus. Similarly, termination for “cause,” which is defined in the agreement and may include actions like misconduct, will also lead to forfeiture. Some agreements provide exceptions for involuntary termination without cause, a term that must be clearly outlined in the contract.

Tax Treatment of Forfeitable Bonuses

The taxation of a forfeitable bonus is governed by the principle of “substantial risk of forfeiture.” Under this principle, a bonus is not taxable income as long as the employee’s right to it is contingent on future performance. The tax event is triggered only when the bonus vests and the risk of forfeiture is removed, at which point the full value of the vested portion becomes income.

Once vested, the bonus is classified as supplemental wages by the Internal Revenue Service (IRS) and is subject to federal income tax, Social Security, and Medicare (FICA) taxes. The employer is responsible for withholding these taxes from the bonus payment.

Employers use one of two methods to calculate the federal income tax withholding on supplemental wages. The first is the “aggregate method,” where the bonus is combined with the employee’s regular wages, and withholding is calculated on the total amount. The second is the “percentage method,” where the employer withholds a flat 22% from the bonus for federal income tax. For supplemental wages over $1 million in a calendar year, a higher 37% withholding rate applies to the excess amount.

The gross amount of the vested bonus is reported as income on the employee’s Form W-2 for that tax year. This inclusion increases the employee’s total taxable income for the year, which could push them into a higher tax bracket and affect their overall tax liability.

Tax Implications of Repayment

An employee may be required to repay a bonus on which they have already paid taxes. This situation arises when an employee leaves the company before fulfilling the service period stipulated in an agreement with a clawback provision. The tax treatment for such a repayment is governed by the “claim of right” doctrine, which provides relief for taxpayers who included an item in gross income in one year and must repay it in a subsequent year.

If the total amount repaid is $3,000 or less, the tax remedy is complicated because the relevant deduction is suspended under tax law through 2025. For repayments of this size that were originally paid as wages, there is currently no mechanism for an employee to recover the federal income taxes paid.

When the repayment amount exceeds $3,000, the employee has two methods of relief. The first option is to take an itemized deduction for the full repayment amount. This deduction reduces the employee’s adjusted gross income for the year of repayment.

The second option is to calculate a tax credit by recomputing the prior year’s tax liability as if the bonus had never been included in income. The difference between the tax originally paid and the recomputed tax is then claimed as a credit in the year of repayment. This method is advantageous if the employee was in a higher tax bracket in the year they received the bonus than in the year they repaid it.

Reviewing Your Bonus Agreement

To understand your rights and obligations, you should carefully review your bonus agreement for the following items:

• The vesting schedule, which will have clear dates and milestones that define when you have earned the compensation.
• The forfeiture events, paying close attention to the definitions and distinctions between voluntary resignation, involuntary termination without cause, and termination for cause.
• Any “clawback” or repayment provisions, which are relevant if the bonus is paid upfront before all vesting conditions are met.
• The repayment terms, which should specify whether you must repay the gross amount of the bonus or the net amount you received after taxes.