December 2, 2021 •Richard Harmon
Bonus season is a cornerstone of the American workplace calendar. The anticipation surrounding holiday and performance-oriented cash compensation borders on expectation. An employee's bonus can make or break their year.
Cash bonuses are ubiquitous, but tax-inefficient.
Employees can expect to lose 30% or more to taxes:
- 22% to federal income taxes (for supplemental income up to $1 million)
- Up to 7.65% is lost to FICA and Medicare
- Bonuses are also subject to state and local income taxes, where applicable
Companies pay standard payroll taxes on bonuses:
- 6.2% for FUTA (Federal Unemployment Tax Act)
- 1.45% for Medicare
Overall, bonus payments can generate a 40% aggregate tax expense.
In addition to lost financial value, year-end bonuses aren’t necessarily an effective long-term retention tool – even if incentives are structured with delayed payouts. While bonuses provide value to employees, this sort of compensation is table stakes in many industries. Supplemental pay programs won’t necessarily yield outsized benefits for a company, but the absence of holiday or performance awards could be a competitive disadvantage.
How can companies reorient bonus packages?
COVID-19 has forced a radical rethinking of corporate benefits overall. In an era where the decentralized office is commonplace and work-life balance is an increasingly sought-after quality, there’s room to augment bonus payment strategies.
That doesn’t mean eliminating cash payouts altogether, but add-on incentives, like additional paid time-off and educational enrichment grants, may offer value for both the company and employees.
Retirement plan expansion is another bonus alternative.
Defined contribution plans can’t be used selectively, but 401(k) match eligibility can be aligned with annual working hours or employment on a certain calendar date. A richer year-end retirement bonus, one that’s already tied to a vesting period, could dovetail with a cash bonus.
Companies do not owe taxes on the match and may claim the contribution as a corporate expense. Employees gain the benefit in a tax-deferred account. From a tax-efficiency standpoint, it outperforms the cash bonus.
Employee stock ownership plans also reward longevity.
Like 401(k) and 403(b) plans, an ESOP is a defined contribution plan. What’s different? Employee stock ownership plans enable full-time workers to hold stock in their company via an employee trust. Shares are either granted or sold to the trust at a fair market valuation.
Stock allocations follow a fixed formula that’s proportional to an employee’s salary. So, unlike cash bonuses, employers can’t pick and choose who gets stock and how much they receive. Allocations occur over a multi-year period (often 10 years or longer) and employees must meet plan-defined vesting requirements.
As a result, contributions can be timed to occur on an annual, year-end basis. And while the shares are a tangible, valuable reward, the potential ESOP benefit is maximized through extended service and can’t be redeemed until the participant departs the employee-owned company.
Employee ownership offers incentives for all stakeholders.
What an ESOP lacks in flexibility, it makes up for in tax efficiency. Contributions are made with pre-tax dollars, companies gain income tax deductions equivalent to the stock’s value, and participants can roll their sale proceeds, without penalty, into another tax-deferred account.
In addition, selective, over-the-top benefits can piggyback an employee ownership plan. One option is stock appreciation rights (SARs). These effectively serve as phantom stock awards for key employees. SARs are established for set periods and can be reallocated. Although stock appreciation rights do not carry the same tax benefits as ESOP allocations, SARs can serve as a flexible, year-end bonus incentive alongside an employee stock ownership plan.
And, of course, a cash bonus program can operate alongside an employee stock ownership plan.
ESOPs are valuable tools, but these incentive plans aren’t overnight solutions.
The formation of an employee stock ownership plan takes months of careful planning, analysis, and coordination. So, ESOP plans aren’t a quick fix for inefficient, end-of-year bonus programs. But if a closely-held company is seriously reevaluating its incentive and retention programs, employee ownership is worth a concerted look. Next year’s holiday season is sooner than you think.