End-of-Year Bonuses: Overtime & Tax Considerations for 2023

Many employers reward and recognize high performers with a bonus, especially toward the end of the year. If you award bonuses, there are several overtime and tax rules to consider. Here’s an overview of some of these rules to help you as you close out the business year in 2023.

Bonuses and overtime pay

Overtime calculations

Under the federal Fair Labor Standards Act (FLSA), employers must pay nonexempt employees overtime at one and a half times their "regular rate of pay" for all hours worked over 40 in a workweek. Some states require overtime under additional circumstances. When calculating an employee's regular rate of pay, employers must include nondiscretionary bonuses.

What is a nondiscretionary bonus?

Most bonuses are considered nondiscretionary under the FLSA and therefore must be included in the regular rate of pay calculation, including those:

Based on a predetermined formula, such as individual or group production bonuses;
Bonuses for quality and accuracy of work;
Bonuses announced to employees to induce them to work more efficiently;
Attendance bonuses; and
Safety bonuses (i.e., number of days without safety incidents).

These bonuses are nondiscretionary because the employee knows about and expects the bonus, and it's based on defined terms. The understanding of how an employee earns the bonus may lead them to expect to receive the bonus regularly. The fact that the employer has the option not to pay the bonus doesn't make the bonus discretionary.

How to calculate overtime with a nondiscretionary bonus

Let’s say a nonexempt employee is paid $12 per hour. In one workweek, they work 50 hours and receive a $100 nondiscretionary productivity bonus. Overtime is calculated as follows:

Step 1: Add straight-time hourly wages for all hours worked and bonus to determine total straight-time compensation.

($12 hourly rate x 50 hours worked) + $100 bonus = $700

Step 2: Divide total straight-time compensation by total hours worked to determine regular rate of pay.

$700 straight-time pay divided by 50 hours worked = $14

Step 3: Multiply regular rate of pay by .5 and then multiply by total overtime hours.

$14 regular rate of pay x .5 overtime premium pay x 10 overtime hours = $70

Since the straight-time earnings have already been calculated for all hours worked (see Step 1), the employee is entitled to an additional 10 hours of overtime premium pay, calculated at one-half the regular rate of pay.

Step 4: Calculate total compensation.

$70 overtime premium pay + $700 straight-time pay = $770

Note: If the nondiscretionary bonus is earned over a single workweek, as is the case above, the bonus is added to the employee's regular earnings for that workweek when determining the regular rate of pay. However, if the bonus is earned over a series of workweeks, the prorated bonus must be included in the regular rate of pay in all overtime weeks covered by the bonus period. If the calculation of the bonus is deferred over a period longer than a workweek, the employer may temporarily disregard the bonus in computing the regular rate until the amount of the bonus can be determined.

In other words, the employer would pay compensation for overtime at 1.5 times the hourly rate until the bonus can be determined. Once the amount of the bonus can be ascertained, it must be apportioned back over the workweeks of the bonus period. The employer must then recalculate the regular rate of pay for each overtime workweek in the bonus period and pay the overtime premium pay due on the bonus.

Example: If an employee receives a $2,600 bonus for meeting certain annual goals, divide $2,600 by 52 weeks ($50/week). Add the $50 to the employee's regular earnings in each workweek the employee worked overtime to figure out the employee's regular rate of pay and overtime due for that week. For any workweek in which the employee worked overtime, you would then need to make catch-up payments for the difference between what you paid the employee in overtime at the time and what the employee is entitled to now that the bonus is known.

State law: Your state law may require a different formula for bonuses. California, for example, requires a different methodology for calculating overtime when an employee receives a flat sum bonus.

Bonuses and overtime exemption

The FLSA allows for exemptions from the overtime requirements for certain employees who work in administrative, professional, executive, highly compensated, outside sales, and computer professional jobs. These employees are known as "exempt" employees. To be considered "exempt," these employees must generally satisfy three tests:

Salary-level test. Employers must pay employees a salary of at least $684 per week to qualify for the executive, administrative, and professional employee exemptions. On August 30, 2023, the DOL released a proposed rule that, if finalized, would increase the minimum salary required to $1,059 per week in order for administrative, professional and executive employees to be considered exempt from the FLSA overtime pay requirements.
Salary-basis test. With very limited exceptions, the employer must pay employees their full salary in any week they perform work, regardless of the quality or quantity of the work.
Duties test. The employee's primary duties must meet certain criteria.

Since 2020, federal law has permitted employers to use nondiscretionary bonuses, incentive payments, and commissions to satisfy up to 10 percent of the federal minimum salary requirement for the administrative, professional, and executive exemptions, as long as these forms of compensation are paid at least annually.

As 2023 comes to a close, ensure you've satisfied this requirement, if applicable. Employers may make one final catch-up payment no later than the next pay period after the end of the year if the bonus, incentive payment, or commission ended up being less than anticipated. For example, if an employer chooses this option, each pay period, the employer must pay their exempt executive, administrative, or professional employee at least 90 percent of the salary level ($615.60 per week). Then, if at the end of year, the employee's paid-out salary plus the nondiscretionary bonuses and incentive payments (including commissions) doesn't equal at least $35,568, the employer would have one pay period to make up for the shortfall.

Note: Some states have their own rules for exemption from overtime that don't allow employers to apply bonuses toward meeting the minimum salary requirement. Therefore, to maintain the overtime exemption under state law, these employers must satisfy the state's requirement with a salary alone.

Tax withholding on bonuses

If you do plan to provide a bonus this year, remember that bonuses are generally considered supplemental wages and are subject to federal taxes as well as certain state taxes. For federal taxes, when an employee receives $1 million or less in supplemental wages during 2023 and those wages are identified separately from regular wages, the flat withholding rate is 22 percent. When an employee receives over $1 million in supplemental wages, the withholding on the supplemental bonus would be 37 percent.

Many types of bonuses are considered taxable by the IRS. For example, cash, a gift certificate, gift card, and similar items that can easily be exchanged for cash are typically considered taxable wages, regardless of the amount (see IRS Publication 15-B). However, if an employer gives a turkey, ham, or other item of nominal value for the holidays, it's generally not considered taxable income. If employers have questions, they should consult their tax advisor.

In the RUN Powered by ADP® (RUN) platform, what is the deadline for running bonus payrolls in 2023?

Be sure to run your 2023 bonus payrolls before the end of the year, by December 29. ADP starts to produce W-2s on January 1. In order to have the correct information, ADP needs the information beforehand.

Conclusion

Bonuses can be an effective and efficient way to drive productivity and employee engagement. If you're paying out bonuses, make sure that your bonus program complies with all applicable federal, state and local rules.

Your Step-by-Step Guide to Calculating Overtime Pay

Review your pay practices to ensure that you are calculating and paying overtime properly. We cover how to calculate overtime in accordance with federal rules.

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