During the past decade, companies of all sizes have migrated away from the traditional compensation model of seniority pay and annual raises. Instead, they now depend more on variations of performance-based pay and incentive bonus plans. Bonuses reflect a company's definition of success and the extent to which that measure is met.

A bonus is an addition to regular salary or compensation that is provided, usually near year-end, to enable employees to share in profits resulting from a successful year.

Bonuses are often used in closely held companies to enable shareholder-employees to withdraw the maximum compensation income from the company each year. Bonuses are used for executives of larger companies as an incentive-oriented form of compensation, based on the attainment of profit or other goals during the year. Bonuses may also be used to assist company owners in funding cross-purchase buy-sell agreements or in contributing their share of the premium for a split dollar arrangement.

Advantages

• Bonuses provide an incentive-based form of compensation that is very effective because of the close connection between performance and reward.
• Bonuses allow flexibility in compensation to reflect company performance, both in closely held and larger corporations.
• Bonus programs are simple to design, despite some tax constraints.

Disadvantages

• Bonuses generally do not offer an opportunity for the employee to defer taxation of compensation for more than one year.
• Bonuses are limited by the requirement of "reasonableness" for the deductibility of compensation payments by the employer.
• Bonuses are taxable to the employee as ordinary income.

Tax Implications

A bonus, together with other compensation, cannot be deducted unless it constitutes a reasonable allowance for services actually rendered. Therefore, bonuses can be very large if they are based on profit or earnings and the company has a very good year.

The IRS can sustain the reality of unreasonably excessive bonus being paid to an employee for two reasons:

• Reasonableness of compensation is often tested in accordance with circumstances existing when the bonus agreement is entered into rather than when the bonus is actually paid.
• In testing the reasonableness of a bonus, both the IRS and the courts will usually take into account the element of risk involved to the employee.

Alternatives

• As with cash compensation in general, taxation can be avoided or deferred by various types of noncash compensation plans including qualified pension and profit sharing plans, nonqualified deferred compensation plans and medical benefit plans.
• Stock option, incentive stock option (ISO) or restricted stock plans are forms of deferred compensation with many of the same incentive features as a cash bonus plan.

How are these plans set up?

Bonus plans can be established as a written agreement or be informally established as verbal agreements. There are no tax or other legal requirements for a written plan or for filing anything with the government. However, a written plan is often desirable, and in that case, employer and the employee may want to consult with a benefit specialist.