Cash Bonuses

Updated: June 04, 2009

"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" (Leimberg and McFadden, p. 309). The above is the opening dialogue provided for in the textbook used in a graduate-level course. A second source defines bonus as "a pay plan that rewards employees for recent performance rather than historical performance" (Robbins and Judge, p. 231). In recent years, the pendulum has been swinging in the direction of paying heavy bonuses, and relying on this aspect of variable compensation. Recent media, including all of the articles on AIG, has drawn considerable attention to this aspect of Wall Street compensation. The purpose of this paper is to define bonus plans, discuss when they are used, and to determine the advantages, disadvantages, and tax implications of cash bonus plans.

"For many jobs, annual bonuses are a significant component of the total compensation. Among Fortune 100 CEOs, the bonus (with a mean of $1.01 million) generally exceeds the base salary (with a mean of $863,000). Increasingly, bonus plans are casting a larger net within organizations to include lower-ranking employees. Many companies now routinely reward production employees with bonuses in the thousands of dollars when company profits improve" (Robbins and Judge, p. 230 and 231). As noted above, cash bonuses are very prevalent. It is also difficult to pick up any financial newspaper these days without reading about this aspect of compensation. Cash bonuses are used as a form of variable compensation that is usually paid in a lump sum and tied to performance, profit, or other goals specified by the employer. Bonuses can be used for individuals, and they can also be used for groups and teams. "Organizations may establish variable pay plans for teams or groups to improve productivity, tie pay to team performance, improve customer service or production quality, and increase employee retention" (Mathis and Jackson, p. 399). There are different triggers for payment of a cash bonus. Some possibilities include the time of year for retention purposes, increased sales, successful teamwork, improvements in safety or attendance, and the list could be more extensive depending on the company. Some companies use bonuses for executives as an incentive and others use spot bonuses, a bonus paid on the spot to reward good performance. A discussion of how bonuses can be used would not be complete without discussing pay for performance and pay-performance relationships. "There can be a direct incentive effect on those who are currently employed by the organization, with different pay systems influencing both the amount of money that can be attained as well as the estimated likelihood of its attainment. These characteristics, in turn, are believed to influence how hard, smart, and persistently people work toward obtaining such rewards" (Gerhart and Rynes, p. 119). "The notion of a relationship between pay practices and characteristics of applicants and employees has been extended to the case of pay basis, or how one pays" (Gerhart and Rynes, p. 119). If one performs well and is compensated each time they perform well with a bonus, one might conclude that their performance is likely to result in compensation and may be motivated to this compensation. The cash bonus is a simple tool that can be used for this type of motivation.

After the discussion above about advantages, it is only fitting to also engage in a discussion of the disadvantages of bonuses. Most of the disadvantages are tax-related. In general, bonuses fail to offer the opportunity for the employee to defer taxation of compensation for more than one year, and they are taxable to the employee as ordinary income (Leimberg and McFadden, p. 309). The tax deferral rules are especially true due to a section of IRS code called 409A, which was added within the last decade. Companies may pay bonuses that are significant either because of a good year or in some cases for retention purposes, as we are especially aware today given the situation with AIG and other similar companies. If the bonuses are considered "reasonable", there could be justifications for deductions. "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." (Leimberg and McFadden, p. 309).

Reference List

Gerhart, B. and Rynes, S.L. (2003). Compensation, Thousand Islands, CA: Sage Publications, Inc.

Leimberg, S.R. & McFadden, J.J.(2007). Employment Benefit And Retirement Planning, Tenth Edition, Cincinnati, OH: The National Underwriter Company

Mathis, R.L. & Jackson, J.H. (2006). Human Resources Management, Eleventh Edition, Mason, OH: Thomson

Reilly, P. & Brown, D. (2008, 4Q). Employee Engagement: What Is the Relationship With Reward Management; WorldatWork Journal, p. 37-47

Robbins S.P.& Judge, T.A. (2009). Organizational Behavior, Thirteenth Edition, Upper Saddle River, NJ: Pearson, Prentice Hall

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