Payroll in Practice: 12.4.2023

Question: An employer is scheduling a $500 year-end bonus for each employee. The company is planning to gross up Social Security and Medicare taxes but does not want to gross up income taxes. Is the employer required to withhold income tax on the bonuses?

Answer: Yes, employers are required to withhold income tax from payments to employees unless either a statutory exclusion from gross income or an exemption from income tax withholding applies to the payment. Failure to withhold and deposit income taxes can result in liabilities and penalties for the employer.

Bonus payments are supplemental pay, by definition, and the supplemental pay rules apply. The employer must either aggregate the bonus with the regular pay for the pay period to compute the amount of income tax to withhold or apply the appropriate federal and state supplemental flat rates to the gross amount of the bonus. The employer may also elect to use an allowable alternative withholding method. In general, the alternative methods are compatible with the aggregate method.

Under the aggregate method, once the total withholding is determined for the pay period, the amount withheld from the supplemental pay is the difference between the total required withholding and the amount withheld from regular pay. The withholding may be computed based on regular pay for either the current or immediately preceding pay period.

For example, on Form W-4, Employee’s Withholding Certificate, an employee claims single or married filing separate with no entries on steps 2, 3, or 4. The pay period is semimonthly, and the Social Security wage base has not been exceeded. The employee’s regular pay for the pay period is $1,000. The employee receives a separate $500 check for the holiday bonus. The employer used the gross-up computation to compute FICA taxes of $41.42.

The gross-up computation combines the tax rates for the taxes included in the gross-up. In this case, the combined tax rate is 7.65% and consists of the 6.2% Social Security tax plus the 1.45% Medicare tax. The bonus is divided by one minus the combined tax rate, or 0.9235, resulting in $541.42 ($500 ÷ 0.9235).

Unless the mandatory flat supplemental rate applies, required income withholding for the bonus can be computed using either the aggregate method or the optional 22% flat rate method.

Table 1A from IRS Publication 15-T, Federal Income Tax Withholding Methods, can be used for the aggregate method. The amount to withhold for $1,000 regular pay is computed first. Based on the employee’s W-4 claims, and the single, semimonthly standard table, the amount to withhold is $42.29. Using the same table, the amount to withhold from $1,541.42, the regular pay plus the grossed-up bonus, is $106.55. The withholding attributable to the bonus is the $64.26 difference between $106.55 and $42.29.

The $64.26 required income tax withholding can be treated as withheld on the date the bonus is paid. It gets deposited along with the employer and employee shares of Social Security tax ($33.57 each) and Medicare tax ($7.85 each) on the appropriate due date for the bonus payment. The $64.26 can be recovered from the employee by withholding from the employee’s regular pay on the next regular pay date.

If use of the optional flat supplemental rate is allowed for an employee, income tax withholding may be computed by applying the specified flat rate to the gross bonus, including any grossed-up Social Security and Medicare taxes. The current rate for federal withholding is 22% unless the mandatory 37% flat rate applies to the payment.

Using the same employee example, the employer could compute income tax withholding of $119.11 (22% of the $541.41 bonus). The deposit and recovery of the income tax withholding could be handled the same way as in the previous example, and the deemed withholding would be recovered from the employee on the next regular pay date.

In both examples, the Social Security and Medicare tax amounts are the same and are actually withheld from the grossed-up bonus. They are not later recovered from the employee since they were withheld at the time the bonus was paid. It is a good idea to advise employees ahead of time that there will be an additional amount withheld from their next regular paychecks to cover income tax withholding on the bonus.

This column does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, North Carolina, and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

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