A holiday bonus paid in cash, by cheque, by direct deposit or as a gift card is taxable wages. The IRS treats bonuses as supplemental wages, so the employer withholds federal income tax using either a flat 22% rate or the aggregate method, and the payment is also subject to Social Security, Medicare and federal unemployment tax. Small non-cash gifts, such as a holiday ham, can be a tax-free de minimis fringe benefit, but cash and cash equivalents never qualify. This guide explains how to run a year-end bonus through payroll correctly, and the separate wage-and-hour question of whether the bonus affects overtime pay.
Bonuses Are Supplemental Wages
The IRS Employer’s Tax Guide, Publication 15, defines supplemental wages as wage payments to an employee that are not regular wages. Its list of examples includes bonuses, commissions, overtime pay, severance, awards, prizes, back pay and retroactive pay increases. A December bonus, a year-end “thank you” payment and a performance award all fall into this category.
Publication 15 is also clear that however you calculate income tax withholding on supplemental wages, “they’re subject to social security, Medicare, and FUTA taxes.” There is no special payroll-tax holiday for holiday bonuses.
Two Ways to Withhold Federal Income Tax
The optional flat rate: 22%
If you withheld income tax from the employee’s regular wages in the current or immediately preceding calendar year, Publication 15 allows you to withhold a flat 22% on supplemental wages, with “no other percentage allowed.” This is the method most payroll systems use for a bonus paid separately from regular pay, because it is simple and predictable.
There is a ceiling. Once an employee’s supplemental wages for the year exceed $1 million, the excess is subject to mandatory withholding at 37%. That will not affect most small business bonuses, but it matters for owners and senior staff with large year-end payments.
The aggregate method
Under the aggregate method you add the bonus to the regular wages for the payroll period, figure withholding on the total as if it were a single payment, subtract the tax already withheld from the regular wages, and withhold the remainder from the bonus. Publication 15 notes that you also include any earlier supplemental payments made in the same payroll period.
The aggregate method can produce higher withholding on a large bonus paid in a normal pay cycle, because the combined payment looks like a much bigger regular paycheque. Employees sometimes see that as the bonus being “taxed more.” The final tax owed is settled on the employee’s annual return; withholding is only a pre-payment.
Gift Cards, Cash and Small Gifts
This is where many small businesses go wrong. The IRS page on de minimis fringe benefits says “cash or cash equivalent items provided by the employer are never excludable from income,” and that cash “cannot be a de minimis fringe benefit.” Gift certificates redeemable for general merchandise are treated as cash equivalents and are taxable.
The same page lists holiday gifts as an example of a de minimis benefit when they are low-value property rather than cash. It also notes that the IRS has ruled that items with a value exceeding $100 could not be considered de minimis.
| Holiday gesture | Typical federal tax treatment |
|---|---|
| Cash or cheque bonus | Supplemental wages: income tax withholding plus Social Security, Medicare and FUTA |
| Gift card usable at a general retailer | Cash equivalent: taxable wages, run through payroll |
| Turkey, ham, fruit basket or similar low-value item | Can be a de minimis fringe benefit, excluded from wages |
| Holiday party for staff | Check IRS Publication 15-B, which covers employer-provided fringe benefits in detail |
If you want to give a gift card, the practical answer is to run its value through payroll as a bonus. Some employers “gross up” the amount so the employee nets the face value; that is allowed but the gross-up itself is also wages.
Does the Bonus Change Overtime Pay?
This is a separate question from tax, and it is governed by the Fair Labor Standards Act rather than the tax code. For non-exempt employees, certain bonuses must be included in the “regular rate” used to calculate overtime. The Department of Labor’s Fact Sheet 56C on bonuses divides them into two groups.
Bonuses you can usually exclude
Gifts on holidays or special occasions can be excluded from the regular rate if the amount is not measured by or dependent on hours worked, production or efficiency. A flat $100 holiday gift to every employee, regardless of hours, typically fits. Discretionary bonuses can also be excluded, but only if the employer keeps sole discretion over both whether to pay and how much until at or near the end of the period, and the bonus is not paid under a prior promise that leads employees to expect it.
Bonuses you usually must include
Nondiscretionary bonuses must be included. The DOL’s examples include bonuses based on a set formula, attendance bonuses, quality and accuracy bonuses, and safety bonuses. If you announced in October that everyone who works every scheduled shift through December 31 gets $300, that is a promised attendance bonus. It has to be included in the regular rate for the weeks it covers, which usually means recalculating overtime for any of those weeks in which the employee worked more than 40 hours.
The label you put on a payment does not decide the issue. Fact Sheet 56C says each case is judged on its facts. Calling a formula-based payment a “Christmas gift” does not make it one.
A Simple Process for Paying a Year-End Bonus
- Decide the type. Discretionary gift, or promised and formula-based? Write it down.
- Choose the payroll run. A separate bonus run usually allows the 22% flat rate. Paying with regular wages generally means the aggregate method.
- Include every tax. Federal income tax, Social Security, Medicare and FUTA, plus any state and local taxes.
- Handle gift cards as wages. Add their value to payroll.
- Recalculate overtime for non-exempt staff if the bonus is nondiscretionary.
- Check the calendar. A bonus paid on December 31 counts for this year’s Form W-2; one paid on January 2 counts for next year. Decide deliberately.
State Taxes
States with an income tax set their own rules for withholding on supplemental wages, and the rates differ. If you have staff in California, taxprosofca.com’s overview of California payroll taxes and EDD obligations explains which agency handles what and when to bring in a professional.
Bonuses are part of the full cost of an employee. If you are setting budgets for next year, our breakdown of the true cost of hiring an employee shows where payroll taxes fit, and our article on whether employers have to pay holiday pay covers the rest of the holiday payroll questions.
Frequently Asked Questions
What is the federal withholding rate on a bonus?
If you use the optional flat-rate method, it is 22% for supplemental wages up to $1 million in the year, and 37% on supplemental wages above $1 million. You can instead use the aggregate method, which adds the bonus to regular wages.
Are gift cards given to employees taxable?
Yes. The IRS treats cash and cash equivalents, including gift certificates redeemable for general merchandise, as never excludable from income. Run their value through payroll.
Is a holiday turkey taxable?
A low-value holiday gift of property, such as a turkey or ham, can be a de minimis fringe benefit and excluded from wages. The IRS lists holiday gifts as an example, and has ruled that items worth over $100 could not be de minimis.
Does a Christmas bonus count toward overtime?
Not if it is a genuine holiday gift that is not measured by hours worked, production or efficiency. If the bonus was promised in advance or is based on a formula or attendance, it is nondiscretionary and must be included in the regular rate for overtime.
Do bonuses have Social Security and Medicare tax?
Yes. IRS Publication 15 says supplemental wages are subject to Social Security, Medicare and FUTA taxes regardless of the income tax withholding method.