December 4, 2023 •Richard Harmon
The holiday season is a cornerstone of the American workplace calendar. The anticipation surrounding discretionary bonuses borders on expectation. Supplemental wages can make or break an employee's 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 (Social Security and Medicare)
- An employee bonus is 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 tax implications, employee bonus aren’t necessarily an effective long-term retention tool – even if incentives are structured with delayed payouts. While an annual bonus can be a valuable component of a workers compensation package, this sort of lump sum payment is table stakes in many industries. Supplemental pay programs won’t necessarily yield outsized business goals, but the absence of holiday or performance bonuses could be a competitive disadvantage.
How can companies reorient employee bonus packages?
The coronavirus pandemic 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 year-end bonus pay strategies.
That doesn’t mean eliminating cash-based, employee bonuses 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 cash 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, annualized 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 a conventional bonus structure.
Employee stock ownership plans also reward loyalty and longevity.
Like 401(k) and 403(b) plans, an ESOP is a defined contribution plan. What’s different? A plan enables eligible employees to hold stock in their company via a trust. Shares are either granted or sold to the trust at a fair market valuation.
Stock allocations follow a non-discretionary formula that’s proportional to an employee’s total compensation (W-2). 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. In certain respects, a well-crafted plan resembles a retention bonus structure.
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.
Employee ownership is also a proven strategy for strengthening company culture. Hard work and exceptional performance in an ESOP context can directly translate to stock value appreciation. Clear financial incentives that motivate employees offer a more durable benefit than a one-time payment.
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, holiday bonus incentive alongside an employee stock ownership plan.
And, of course, a discretionary 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 several months of careful planning, analysis, and coordination. So, ESOP plans aren’t a quick fix for inefficient, holiday bonus programs.
But if a closely-held company is seriously reevaluating its bonus structures and employee retention strategies, employee ownership is worth a concerted look. Next year’s holiday season is sooner than you think.