What is it?

1. What is it? An addition to regular salary or compensation that is provided, usually near year end, to enable employees to share in the profits of a successful year.

2. When is it indicated? • to enable shareholder-employees in closely held companies to withdraw maximum compensation income from the company each year • to provide executives of larger corporations an incentive-oriented compensation based on attaining profit or other goals during year • to assist executives in funding cross-purchase buy-sell agreement or in contributing their share of premium in split-dollar arrangement

3. Advantages • provides effective incentive-based form of compensation • allows compensation to reflect company performance in closely held and larger corporations • flexible and simple to design

4. Disadvantages • no opportunity for employee to defer taxation of compensation for more than one year • tax deduction for employer limited by ‘reasonableness’ requirement • bonuses taxable to employee as ordinary income

5. Tax Implications • a bonus cannot be deducted unless it constitutes a reasonable allowance for services actually rendered • no deduction permitted for compensation >$1,000,000 paid to certain top executives of publicly held corporations

6. Tax Implications • bonuses CAN be large IF based on profits or earnings and the company has a very good year • reasonableness of compensation often tested in accord with circumstances existing when entered bonus agreement vs. when bonus paid • IRS and courts consider the risk faced by employee

7. Tax Implications • plan ahead when using bonuses as employee compensation to be able to defend ‘reasonableness’ of compensation • 2½ month safe harbor rule an accrual method corporation can deduct a compensation payment that is properly accrued before the end of a given year, so long as the payment is made no later than 2½ months after the end of the corporation’s taxable year

8. Tax Implications • regular employees can use the 2½ month safe harbor technique to move taxable income to the employee’s next taxable year e.g. corporation deducts bonus earned in 2009, bonus paid to employee on March 15, 2010; employee can defer tax payment to April 15, 2010

9. Alternatives • can avoid or defer tax with noncash compensation plans, e.g. • qualified pension and profit sharing plans • nonqualified deferred compensation plans • medical benefit plans • stock-based plans also offer performance-based incentive • stock optoin • incentive stock option (ISO) • restricted stock plans

10. How are these plans set up? • can be informal, even oral! • no tax or legal requirement for written plan or for filing anything with the government • best if employer and employee develop written plan in consult with an attorney

11. True or False? • A bonus is considered part of regular salary. • The only reason to use a bonus is to create a performance incentive. • Bonus arrangements are simple because they face no tax constraints other than their treatment as ordinary income.

12. True or False? • The ‘reasonableness of compensation’ rule effectively limits all bonuses to all types of employees to only a small percentage of usual compensation. • A bonus plan must be written.

13. Discussion Question What are the advantages of having a written bonus plan?