Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
What is it?
An addition to regular salary or compensation that is
provided, usually near year end, to enable employees to
share in the profits of a successful year.
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
When is it indicated?
• to enable shareholder-employees in closely held
companies to withdraw maximum compensation
income from the company each year
• to provide executives of larger corporations an
incentive-oriented compensation based on attaining
profit or other goals during year
• to assist executives in funding cross-purchase buysell agreement or in contributing their share of
premium in split-dollar arrangement
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Advantages
•
•
•
provides effective incentive-based form of
compensation
allows compensation to reflect company
performance in closely held and larger corporations
flexible and simple to design
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Disadvantages
•
•
•
no opportunity for employee to defer taxation of
compensation for more than one year
tax deduction for employer limited by
‘reasonableness’ requirement
bonuses taxable to employee as ordinary income
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Tax Implications
•
•
a bonus cannot be deducted unless it constitutes a
reasonable allowance for services actually
rendered
no deduction permitted for compensation
>$1,000,000 paid to certain top executives of
publicly held corporations
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Tax Implications
•
bonuses CAN be large IF based on profits or
earnings and the company has a very good year
– reasonableness of compensation often tested in accord
with circumstances existing when entered bonus
agreement vs. when bonus paid
– IRS and courts consider the risk faced by employee
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Tax Implications
• plan ahead when using bonuses as employee
compensation to be able to defend ‘reasonableness’
of compensation
• 2½ month safe harbor rule
an accrual method corporation can deduct a compensation
payment that is properly accrued before the end of a given year,
so long as the payment is made no later than 2½ months after
the end of the corporation’s taxable year
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Tax Implications
• regular employees can use the 2½ month safe
harbor technique to move taxable income to the
employee’s next taxable year
e.g. corporation deducts bonus earned in 2009, bonus paid to
employee on March 15, 2010; employee can defer tax payment
to April 15, 2010
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Alternatives
1.
can avoid or defer tax with noncash compensation
plans, e.g.
–
–
–
2.
qualified pension and profit sharing plans
nonqualified deferred compensation plans
medical benefit plans
stock-based plans also offer performance-based
incentive
–
–
–
stock optoin
incentive stock option (ISO)
restricted stock plans
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
How are these plans set up?
• can be informal, even oral!
• no tax or legal requirement for written plan or for filing
anything with the government
• best if employer and employee develop written plan
in consult with an attorney
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
True or False?
1. A bonus is considered part of regular salary.
2. The only reason to use a bonus is to create a
performance incentive.
3. Bonus arrangements are simple because they face
no tax constraints other than their treatment as
ordinary income.
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
True or False?
4. The ‘reasonableness of compensation’ rule effectively
limits all bonuses to all types of employees to only a
small percentage of usual compensation.
5. A bonus plan must be written.
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Bonus Plan
Chapter 32
Employee Benefit & Retirement Planning
Discussion Question
What are the advantages of having a written bonus
plan?
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