End-of-Year Bonus: Tax Implications and Record-Keeping Tips

An end-of-the-year bonus is a highly sought-after financial boost for many hardworking professionals. The bonuses are calculated and given based on various factors, like employee performance, the company's success, retention efforts, etc. While they can significantly boost a worker’s income, they are also taxable and need to be handled accordingly.

In this article, we’ll explain exactly what an end-of-the-year bonus is and what the different types are. We’ll see who is entitled to these bonuses, how they are calculated, what the tax implications are, how companies typically handle year-end bonuses, and how they should be documented.

What Is an End-of-the-Year Bonus?

An end-of-the-year bonus is an optional form of compensation that employers can give to employees in addition to their regular wages. It’s typically given in December, though it can be issued in November and January, as well.

The bonus is a way for companies to share their successes from the previous twelve months and give employees financial boosts for the holiday season. From the employer’s standpoint, the bonus is primarily used as a reward for performance, a retention incentive, or as part of a contractual obligation.

Bonuses can be calculated in several ways. They can be fixed amounts, percentages of employees’ annual salaries, or based on the performance of the worker or the company. Regardless of how they are calculated, year-end bonuses are almost always issued as a lump sum.

When it comes to taxes, the IRS recognizes end-of-the-year bonuses as supplemental pay. This means they need to be reported and taxed as such.

Discretionary vs. Non-Discretionary bonuses

There are two distinct categories of end-of-the-year bonuses, according to the FLSA:

1. Discretionary bonuses are provided entirely at an employer’s discretion. They are given completely spontaneously and without any written agreements or promises given in advance. Because of that, these bonuses are excluded from overtime calculations for non-exempt employees.
2. Non-discretionary bonuses are promised in advance and are expected payments. Moreover, they are given based on specific criteria, such as meeting certain targets, reaching goals, exceeding KPIs, maintaining attendance, and so on. Since they are tied to performance, they must be factored into an employee’s regular pay rate and can affect overtime calculations.

Who Is Entitled to End-of-the-Year Bonuses?

Determining who is entitled to an end-of-the-year bonus comes down to a company’s policy, employee’s contract, or mutual agreement. There’s no federal law that requires employers to give year-end bonuses, but if a non-discretionary bonus is a part of a formal and legal agreement, the employer must fulfill their end of the bargain.

In general, any employee is eligible for an end-of-the-year bonus. The most common recipients are full-time W-2 employees in performance-oriented fields and roles (e.g., executive, corporate, sales).

Here are some of the common criteria employers use to determine who’ll get an end-of-the-year bonus:

• Length of employment.
• Individual, team, or company performance.
• Retention agreements.

Upper and middle management typically receive scalable payouts, based on their department's efficiency or company profitability. On the other hand, entry-level staff generally receive flat amounts that are company-wide.

Part-time employees can also receive end-of-the-year bonuses, like full-time workers, but their payouts are usually calculated based on how many hours they worked that year.

Apart from W-2 employees, freelancers and independent contractors can also receive year-end bonuses. While they aren’t on the company payroll, these professionals can still be awarded for their exceptional performance (e.g., delivering outstanding quality or exceeding deadlines).

It’s important to note that bonuses to independent contractors must be treated as additional compensation and reported properly. They need to be directly related to specific projects and milestones, and not be broad rewards for general metrics. This is important to avoid worker misclassification risks and troubles with the IRS.

The bottom line is that entitlement to end-of-the-year bonuses is a part of an agreement. It’s a financial tool that encourages the company and its employees to work as a team and benefit from mutual accomplishments.

Tax Implications of an End-of-the-Year Bonus

End-of-the-year bonuses are taxable income. This means they are subject to federal income tax, Social Security, and Medicare taxes, at a minimum. Depending on your location, there may also be some state and local taxes.

Here’s a quick comparison between W-2 employees and 1099 contractors in terms of tax and end-of-year-bonuses:

W-2 Employees

As we’ve already mentioned, end-of-the-year bonuses given to W-2 employees are treated as supplemental wages. This means employers can use one of the two methods for withholding tax:

• Flat rate method. This is a simpler method that most employers use. It involves applying a flat tax rate of 22% for bonuses under $1 million. If a bonus is over $1 million, the rate increases to 37% for any amounts over that threshold.
• Aggregate method. This method involves combining year-end bonuses with regular wages for that pay period. Following that, the employer calculates federal withholdings from the entire sum using standard income tax brackets. As a result, this method can put you into a higher tax bracket for that period, reducing your take-home pay.

In addition to that, supplemental wages are also subject to deductions on account of Social Security (6.2%) and Medicare tax (1.45%).

Plus, there may be state and local income taxes, depending on your location. Finally, there may also be state supplemental taxes to keep in mind, which can eat into your take-home pay even further.

1099 Contractors

Taxes on 1099 bonus payments to contractors are treated completely differently compared to W-2 employees. Since these professionals are self-employed, the clients who give them bonuses don’t withhold any taxes from them (federal, state, or payroll). Simply put, if a company gives the contractor a $1,000 bonus, they receive the entire sum.

However, that doesn’t mean the bonus is tax-free. Instead, independent contractors must report any income they receive from clients (regular payments and bonuses alike) on their tax returns (typically on Schedule C).

Any amount received as an end-of-the-year bonus goes into the contractor’s gross income. From there, the contractor will need to pay income tax based on their bracket, as well as 15.3% self-employment tax, which covers both the employer’s and employee’s share of Social Security and Medicare.

Additionally, since independent contractors don’t have tax withheld from their paychecks every pay period, they generally have to pay quarterly estimated tax (Form 1040-ES). This helps them cover expected tax liability, stay on top of what they owe to prevent underpayment, and avoid a big tax bill at the end of the year.

How Are End-of-the-Year Bonuses Calculated?

End-of-the-year bonuses are calculated using several different methods that are primarily influenced by the company’s industry, budget, and goals.

Two standard methods for end-of-the-year bonus calculation are:

• The flat-rate method
• The percentage method

The flat rate method is more straightforward and equitable. It’s common for small businesses or in large departments, where companies can offer set dollar amounts to all employees. They can also tie a bonus to a specific performance target, like in the following example:

• Flat bonus example: $5,000 end-of-the-year bonus if an employee meets 90% of their performance targets.
  

The percentage method typically involves using an employee’s base salary. Here is an example:

• Percentage bonus example: Employee has a base annual salary of $80,000, and the bonus is 10% if they meet their performance targets. This amounts to an $8,000 end-of-the-year bonus.

While using one of these two methods, employers can also account for the company’s profitability, the performance of the employee’s department, or individual evaluations.

How Companies Typically Handle End-of-Year Bonuses

Handling end-of-the-year bonuses requires planning from the HR and payroll perspectives. It involves determining when the bonuses should be paid, in what amounts, how, and to whom. Carefully executing all these steps ensures employee satisfaction and legal compliance.

When Are the Bonuses Paid?

End-of-the-year bonuses are generally paid between late November and early January.

Since the timing is meant to align with the holiday season, most employers pay these bonuses in December. This is done to provide employees with extra funds (which is why the bonus is also referred to as the 13th-month pay) for a period when personal expenses are typically the highest.

However, some companies often postpone payments of these bonuses until January. This gives them enough time to finish with the year-end payroll activities, know their exact annual profits, and figure out the right amounts for bonuses.

It’s important to note that bonuses paid out in January may also push the employee’s tax liability for them into the next calendar year.

Methods of Payment

Employers typically pay end-of-the-year bonuses using one of the two methods:

• Using a separate paycheck for the bonus.
• Including the bonus in the regular payroll.

The holiday bonus payment can be done via a direct deposit, cash, a physical check, or by any other method that the organization uses to pay its employees. Many employees prefer to receive a bonus separate from their payroll, as it feels like a distinct reward.

Any regulated payment method is legal, provided the payment has been reported and recorded with appropriate bonus income documentation.

Here are the key mistakes to avoid to ensure compliance:

• Misclassifying the bonus and not distinguishing between discretionary and non-discretionary payments, and then failing to account for overtime (for non-discretionary bonuses)
• Forgetting payroll taxes (Social Security and Medicare) or not calculating withholding accurately.
• Not documenting bonuses properly (via pay stubs, Forms W-2, or Forms 1099 for contractors) or failing to keep the records for at least three years.

Documenting Your Bonus with Pay Stubs or Invoices

As we’ve established, documenting bonuses with pay stubs, invoices, and other relevant documentation is critical in ensuring compliance. Regardless of the type of bonus or the payment method, the transaction needs to appear in an employee’s pay stub or a contractor’s invoice and Form 1099 (as long as it’s more than $600 in a year).

If you’re an employer, you need to include an end-of-the-year bonus in a pay stub for your employee as an item separate from their regular wages. The pay stub needs to show a gross amount and have the correct amount of tax applied to it.

The documenting procedure is just as important for independent contractors, who should generate and send a unique invoice for bonus payment. This invoice should have a distinct line labeled as “End-of-the-Year Performance Bonus” or “Early Completion Incentive.”

That way, the contractor clearly communicates the intent behind the invoice while also maintaining records of the payment and showing that the compensation wasn’t wage-related.

Record End-of-the-Year Bonuses with Paystub.org

At Paystub.org, we can help you create professional and accurate documentation to issue and record end-of-the-year bonuses. Our tools can help you with pay stubs, invoices, and even bonus reporting via W-2 forms and 1099 forms.

Our software comes with ready-made templates, built-in calculators for rates and taxes, autosaving features, and more. Here are the tools that we offer:

• Pay stub generator
• Form W-2 generator
• Invoice generator
• Form 1099 generator

Final Thoughts

An end-of-the-year bonus offers a great way to reward your employees, share your successes, and improve their morale and loyalty. However, it’s important to distribute these bonuses properly, ensure compliance with all the relevant laws and regulations, and document everything for tax and recordkeeping purposes.

Be mindful of the details (e.g., whether a bonus is discretionary or non-discretionary), careful with taxes, and straightforward in communication with your employees. Don’t forget to put everything in writing and keep all the records on file for at least three years. If you need any help with that, feel free to use our software at Paystub.org.

End-of-the-Year Bonus FAQs

#1. Can contractors receive a year-end bonus?

Yes, contractors can receive a year-end bonus. However, the bonus must be tied directly to a specific project or included in a contract from the beginning. Otherwise, there’s the risk of worker misclassification, which can trigger an audit and result in penalties.

#2. Should I request a pay stub for my bonus?

Yes, you should request a pay stub for your bonus if you’re a W-2 employee. Since an end-of-the-year bonus is categorized as supplemental income, it needs to be recorded, reported, and taxed properly. This includes the amount showing in the income section of your pay stub.

#3. Do bonuses affect my 1099 income?

Yes, bonuses affect your 1099 income. They increase your gross income, which you must then report to pay self-employment taxes. Since no taxes are withheld by employers upfront, your exact liability will be determined when you file your tax return.