Several temporary tax cuts are set to expire in 2011, and that means companies may want to consider dishing out bonuses early this year.
The highest federal income tax rate is scheduled to climb 4.6% to 39.6% on Jan. 1, 2011 when many temporary tax cuts run their course.
What a difference a day makes
So what’s that mean for you? It may be wise to consider paying out some employee bonuses by Dec. 31, 2010. Waiting to pay them out in 2011, when the tax rates increase, could cost your workers some serious dough, according to the tax experts at the law firm Vorys, Sater, Seymour and Pease, LLP.
However, this decision isn’t as cut-and-dried as it sounds. Before making any payments early, Vorys warns that companies must make sure that the payments don’t result in adverse tax consequences or a loss of deduction under these two important sections of the Internal Revenue Service tax code:
Section 409A
For companies with fiscal years that end on Dec. 31, 2010, discretionary bonuses and incentive compensation payments that you would normally pay out by March 15, 2011 can be made prior to Dec. 31, 2010 without any adverse tax consequences.
However, here’s where it gets tricky. If you’d normally pay bonuses after March 15, 2011 the bonuses are considered “deferred compensation” and would be subject to Section 409A, which requires these payments to be made at an “objectively determinable and non-discretionary” time — and not earlier. If payment is made early, a 20% additional income tax (plus interest and penalties) would be imposed on each employee receiving an early payment.
Section 162(m)
Public companies’ “performance-based compensation” bonus payments under this section are subject to special limitations.
Example: Before any payment can be made, a compensation committee must first certify that an employee’s — or group of employees’ — performance goals have been met.
Normally that wouldn’t happen until the end of the fiscal year (January 2011 or later). But if the performance targets have been achieved early, the committee can allow the bonus payment to be made prior to Jan. 1, 2011 without any adverse tax consequences.
Now if only part of the performance goals have been achieved, the committee can allow a partial bonus payment — if it follows these guidelines:
Suppose an employee — or group of employees — is projected to meet 95% of its annual target goal by the end of 2010, the compensation committee can certify that 70% of the annual goal has been met (leaving a substantial cushion in case there’s a drop off in performance by year’s end), and a partial bonus payment can be issued. The committee can then measure performance again in 2011 and issue the rest of the bonus payment, which would be subject to the new tax rate.