Ways to Recognize Employees: Their Tax Implications

It doesn’t cost you anything to say “thank you” to employees who do a good job for your company, and there are no tax implications here. But if you want to do more to recognize their accomplishments and retain them as valued employees, there are many things you can do.

Tax Rules for Paying Employees Extra

Whenever money is involved, tax implications follow. Also keep in mind the growing trend in state law of pay transparency; what you do for one employee may be known to all your staff.

Cash

Whatever label you put on it, cash or cash equivalents are treated as taxable compensation. Employees are taxed on bonuses while the company can deduct the payment (assuming total compensation to the employee is reasonable). The bonuses are subject to payroll taxes too.

• Bonuses. Who doesn’t want more money, so giving a bonus—not just an annual one, but rather one tied to a specific achievement—will be a welcome reward.
• Anniversary gifts. No, this isn’t related to an employee’s marital status; it’s to recognize how long the employee has been with the company. A monetary gift may be warranted, and Oracle Netsuite suggests it be a percentage of salary and that the percentage grow each year.
• Gift cards. Even though this is a small monetary gesture, it’s still a sign of recognition and treated the same for tax purposes.

Fringe benefits

Above and beyond compensation, various perks can be just the thing to acknowledge a valued employee. Consider helping employees pay their student loans, pursue education, or defray the cost of childcare. Many fringe benefits must be provided on a nondiscriminatory basis for favorable tax rules to apply to employees and the business. And they usually are offered on an annual basis and are not tied to job performance. This means most can’t be used to single out a single employee who’s done an excellent job on a particular project. Nonetheless, check the list of potential benefits in IRS Publication 15-B.

Note that if you provide transportation benefits—free parking, transit passes, or van pooling—you can’t deduct your cost even though the benefit (up to $300 per month in 2023) is tax free to employees and not subject to payroll taxes.

Time off

If employees have been working especially hard and you want to reward them, then give them time off. If the time off is paid leave, it’s treated as regular compensation; the rules discussed earlier apply. Time off can be for:

• Volunteer work. Employees may be involved in organizations or support ones that company chooses.
• Sabbaticals. Small businesses may not be able to have an employee away from the company for an extended period of time. Still, a paid sabbatical may be appropriate for certain employees, such as a manager or someone engaged in artistic activities.

Share ownership

If you really want to show appreciation to your staff—and get them to commit even more to your company’s success—consider sharing ownership with your staff. There are several ways to do this if your business is incorporated:

• Give stock to employees as compensation. If you are a C corporation and aren’t in certain service industries, employees can get 100% tax-free gain up to $10 million as long as they’ve held the stock (called Section 1202 stock or qualified small business stock as explained in the instructions to Schedule D of Form 1040) for more than 5 years.
• Employee Stock Option Plan (ESOP). Both C and S corporations can set up a retirement-like plan funded with employer stock. There are tax benefits to both employees and owners:
  • Contributions of stock are tax deductible by the corporation (limitations apply)
  • Cash contributions to the ESOP so it can purchase stock from existing owners is deductible
  • Owners who sell their shares can achieve tax deferral on the gain from this sale if certain conditions are met
  • Employees who participate in an ESOP are treated much the same way as they are with respect to employer contributions to a 401(k); no tax to employees until they receive distributions.

Learn more about ESOPs through the National Center for Employee Ownership.

• Grant stock options. This gives employees the right to exercise the options and acquire stock. These can be:
  • Incentive stock options (ISOs). These are typically used by publicly traded corporations, so no further explanation is needed here.
  • Nonqualified employee stock options. These are options that don’t meet the requirements to be ISOs.
  • Qualified equity grants. These grants allow employees in privately-held corporations to defer income from if the company provides an escrow arrangement to hold the shares until the correct amount is withheld from employees’ pay at the end of the deferral period. The Tax Adviser has a good explanation of this benefit.

Conclusion

Listen to what your employees would like, consult your budget, and offer what you can. If you can’t afford a big reward, even a small gesture—a written thank-you note, an Employee of the Month award, or a favored parking spot—can go a long way in showing your appreciation.

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This article, "Ways to Recognize Employees: Their Tax Implications" was first published on Small Business Trends