Bonus: Definition, Different Types, and Tax Treatment

What Is a Bonus?

A bonus is a financial compensation that is above and beyond the normal payment expectations of its recipient. Companies may award bonuses to both entry-level employees and to senior-level executives. While bonuses are traditionally given to exceptional workers, employers sometimes dole out bonuses company-wide to stave off jealousy among staffers.

Bonuses may be dangled as incentives to prospective employees and they can be given to current employees to reward performance and increase employee retention. Companies can distribute bonuses to its existing shareholders through a bonus issue, which is an offer of free additional shares of the company's stock.

Understanding Bonuses

In workplace settings, a bonus is a type of additional compensation an employer gives to an employee that complements their base pay or salary. A company may use bonuses to reward achievements, to show gratitude to employees who meet longevity milestones, or to entice not-yet employees to join a company's ranks.

Bonuses can take various forms, including cash, stock, or stock options. They can be given to individuals, teams, or the entire company. Companies may also offer incentive bonuses, such as signing bonuses for new hires, referral bonuses for employees who refer successful candidates, and retention bonuses to encourage employee loyalty. Performance bonuses are given for exceptional work and can be given as annual bonuses, spot bonuses, or milestone bonuses.

In the United States, bonuses are considered taxable income by the Internal Revenue Service (IRS). This means that employees are required to report their bonuses as part of their taxable income when they file their taxes. The employer is also required to report the bonus to the IRS and to withhold taxes from the employee's bonus payment at the time it is paid. The amount of tax withheld from a bonus payment is based on the employee's tax bracket and the tax laws in effect at the time the bonus is paid.

It's important for employees to be aware of the tax implications of bonuses, as failing to report them can result in penalties and interest charges from the IRS. Employees should keep good records of their bonus payments and consult with a tax professional if they have any questions about how to report their bonuses on their tax return.

Incentive Bonuses

Incentive bonuses include signing bonuses, referral bonuses, and retention bonuses. A signing bonus is a monetary offer that companies extend to top-talent candidates to entice them to accept a position—especially if they are being aggressively pursued by rival firms. In theory, paying an initial bonus payment will result in greater company profits down the line. Signing bonuses are routinely offered by professional sports teams attempting to lure top-tier athletes away from competitive clubs.

Referral bonuses are presented to employees who recommend candidates for open positions, which ultimately leads to the hiring of said candidates. Referral bonuses incentivize employees to refer prospects with strong work ethics, sharp skills, and positive attitudes.

Companies offer retention bonuses to key employees, in an effort to encourage loyalty, especially in downward economies or periods of organizational changes. This financial incentive is an expression of gratitude that lets employees know their jobs are secure over the long haul.

Holiday Bonuses

Some companies hand out bonuses specifically during the December holidays season. Holiday bonuses can take various forms, such as cash, gift cards, or other types of gifts. They can be given to individual employees or to the entire company. Some companies give holiday bonuses to all of their employees, while others only give them to certain employees, such as those who have been with the company for a certain length of time or who have achieved certain performance goals.

Some countries have codified holidays bonuses as part of the labor law. Aguinaldo, for example, is an annual Christmas bonus that businesses in Mexico are required by law to pay to their employees. The payment, sometimes called the "thirteenth salary," must be made by Dec. 20 of each year. It is usually equivalent to 15 days of the employee's salary. It is typically given to all employees, regardless of their job title or length of service. Companies that fail to make an Aguinaldo payment may be fined as much as 5,000 times the legal daily minimum wage. Some other Latin American nations, such as Costa Rica and El Salvador, also require employers to pay their employees an Aguinaldo.

Performance Bonuses

Performance bonuses reward employees for exceptional work. They are customarily offered after the completion of projects or at the end of fiscal quarters or years. Performance bonuses may be doled out to individuals, teams, departments, or to the company-wide staff. A reward bonus may be either a one-time offer or a periodic payment. While reward bonuses are usually given in cash, they sometimes take the form of stock compensation, gift cards, time off, holiday turkeys, or simple verbal expressions of appreciation.

Examples of reward bonuses include annual bonuses, spot bonus awards, and milestone bonuses. Spot bonuses, which reward employees who deserve special recognition, are micro-bonus payments, typically valued at around $50. Workers who reach longevity milestones—for example, 10 years of employment with a given firm—may be recognized with additional compensation.

Some businesses build bonus structures into employee contracts, where any profits earned during a fiscal year will be shared amongst the employees. In most cases, C-suite executives are awarded larger bonuses than lower-level employees.

Bonus Inflation

While bonuses are traditionally issued to high-performing, profit-generating employees, some companies opt to issue bonuses to lower-performing employees as well, even though businesses that do this tend to grow more slowly and generate less money. Some businesses resort to distributing across-the-board bonuses in an effort to quell jealousies and employee backlash. After all, it's easier for management to pay bonuses to everyone than to explain to inadequate performers why they were denied.

Furthermore, it can be difficult for an employer to accurately assess their employees' performance success. For example, employees who fail to make their activity quotas may be very hard workers. However, their performance may be hampered by any number of conditions out of their control, such as unavoidable production delays or an economic downturn.

Special Considerations

Bonuses in Lieu of Pay

Companies are increasingly replacing raises with bonuses—a trend that vexes many employees. While employers can keep wage increases low by pledging to fill pay gaps with bonuses, they are under no obligation to follow through. Because employers pay bonuses on a discretionary basis, they may keep their fixed costs low by withholding bonuses during slow years or recessionary periods. This approach is much more viable than increasing salaries annually, only to cut wages during a recession.

Dividends and Bonus Shares

In addition to employees, shareholders may receive bonuses in the shape of dividends, which are carved from the profits realized by the company. In lieu of cash dividends, a company can issue bonus shares to investors. If the company is short on cash, the bonus shares of company stock provide a way for it to reward shareholders who expect a regular income from owning the company's stock. The shareholders may then sell the bonus shares to meet their cash needs or they can opt to hold onto the shares.

The Bottom Line

A bonus is a financial reward that is given to an employee beyond their normal salary or wages. It can be given as an incentive to encourage certain behavior or to reward good performance. Bonuses can take various forms, including cash, stock, or stock options, and can be given to individuals, teams, or the entire company. Incentive bonuses include signing bonuses for new hires, referral bonuses for employees who refer successful candidates, and retention bonuses to encourage employee loyalty. Performance bonuses are given for exceptional work and can be given as annual bonuses, spot bonuses, or milestone bonuses. The Internal Revenue Service (IRS) considers bonuses as taxable income, so employees need to report them when filing their taxes.