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Payroll in Practice: 5.2.2022

May 2, 2022, 7:02 PM

Question: An employer is planning to pay a nondiscretionary bonus to hourly employees. How are the revised regular rate of pay and revised overtime rate computed?

Answer: A nondiscretionary bonus is a bonus that does not qualify as a discretionary bonus. Under regulation 23 CFR 778.211, for a bonus to be considered discretionary the employer must retain the right to determine not only the amount of the payment but whether the payment will be made, until shortly before the bonus is paid.

While a discretionary bonus is not included in the regular rate of pay for the purposes of computing overtime compensation, a nondiscretionary bonus generally must be included in the regular rate of pay. There are certain exceptions to inclusion, such as a bonus paid under a qualified profit-sharing plan.

Since overtime compensation is determined by the regular rate of pay of each employee each workweek, the employer must determine which workweeks are covered by the bonus and allocate the bonus amount accordingly.

If the bonus is based on a formula linked to compensation, the allocation may be based on the amount of compensation attributable to each workweek. To calculate the allocation, the compensation for a given workweek is divided by the total compensation for the bonus period. This gives the percentage of the bonus to allocate to that workweek. If the bonus has some other basis that can be traced back to the individual workweeks, such as hours worked, then that basis may be used.

If the amount of bonus attributable to each workweek cannot be determined, the employer should allocate the bonus equally to each workweek.

For each workweek that overtime was paid to the employee, the employer is to add the bonus allocated to that workweek to the regular pay for that workweek. The regular pay for the workweek is the original regular hourly rate of pay multiplied by the number of hours worked, including overtime hours.

For example, if the regular rate of pay is $10 per hour and the employee worked 45 hours, the total straight time (regular) pay for the workweek is $450 (45 hours x $10). If the amount of bonus allocated to the workweek is $45, the regular pay for the workweek becomes $495. The regular rate of pay for the workweek after adding the bonus becomes $11 per hour, determined by dividing $495 by the 45 hours worked during that week.

The employer then computes the difference between the overtime premium at the new rate and the premium at the original rate. In the example, the previous overtime premium was $5 for each overtime hour ($10 x 0.5) and the new rate is $5.50 ($11 x 0.5). The difference is $0.50 ($5.50 - $5).

The additional compensation owed to the employee because of the bonus is the increase in the regular rate multiplied by the number of overtime hours worked during the workweek. In the example, the employee worked five hours of overtime, was paid $25 ($5 x 5 hours) overtime premium for the workweek on the regular payday and is due an additional $2.50 ($0.50 x 5 hours) overtime premium for that workweek when the bonus is paid.

An alternative, and perhaps easier, method is to allocate the bonus equally to each hour worked.

For example, say a $400 bonus is attributable to a month during which the employee worked 178 hours, including 18 overtime hours. The additional regular hourly pay resulting from the bonus is $2.247 per hour and is rounded to $2.25 ($400 / 178 hours) in this example.

The additional overtime premium for the month is $20.25 ($2.25 x 0.5 x 18 hours), and the employee would receive total bonus of $420.25.

This method generally results in a higher average overtime rate on the bonus than would be generated by allocation to each workweek. On that basis, it is an acceptable method of computing the additional overtime.

Question: If the members of a particular limited liability company are exempt from state unemployment insurance coverage, are they also exempt from federal unemployment coverage?

Answer: State unemployment insurance and federal unemployment (FUTA) rules may vary as to who is a covered employee, based on factors such as the employee’s occupation, the ownership interest in the business, or the tax status of the business. A particular individual may be covered under one program and not the other.

In the case of an LLC, members of the LLC are owners. For FUTA purposes, whether the owner of a business is subject to unemployment tax depends, in part, on the relationship between the owner and the business.

For a business that is a sole proprietorship, a partnership, or an LLC that is treated as a partnership for federal tax purposes, the member-owners are self-employed and generally are not eligible for unemployment compensation. No FUTA tax should be paid on the owner’s earnings.

A single-member LLC also would be exempt from FUTA coverage if it is owned by an individual or a partnership that is a disregarded entity, which is an LLC that has only one member, regardless of the entity type of the owner, and has not affirmatively elected to be treated as a corporation. The entity is disregarded for federal income tax purposes, and the owner is the taxable entity.

Regardless of what a proprietorship or partnership calls the owner’s compensation, the owner is not an employee for tax purposes. The owner’s compensation is treated as self-employment income and does not constitute wages or salary. Income and employment taxes should not be withheld from the compensation of the proprietor or owners.

Self-employed business owners are taxed on their individual share of the net income of the business and other pass-through income. If a tax liability is expected, the proprietor or partner should make estimated tax payments in lieu of withholding.

If the business is incorporated or is an entity treated as a corporation – such as an LLC electing to be treated as a corporation – the owner is an employee and is usually treated as such for unemployment tax purposes. For example, salary paid to an owner-employee of an S corporation is subject to federal unemployment tax. This is true even if the business has no other employees. That is, the business and the owner are treated as separate entities for tax purposes.

State laws may vary as to coverage and benefit eligibility of owner-employees, officers, or directors. However, if the owner is the only employee, the owner is generally not subject to termination of employment with the business. On that basis, the company’s state unemployment tax rate may tend to be low. If reserve requirements are met, it is possible for the overall rate to be very low in most states.

The FUTA coverage for LLC members depends on the federal tax status of the LLC. If the LLC is classified as a partnership or proprietorship for federal tax purposes, the members are exempt from FUTA just as partners and sole proprietors would be exempt from FUTA. Self-employment is not employment for FUTA purposes.

If the LLC has elected corporate status, including S-corporation status, the owners who work for the LLC are employees and are subject to FUTA if the coverage requirements are met. As stated earlier, federal and state coverage requirements may differ.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., or its owners.

Author Information

Patrick Haggerty is the owner of a tax practice in Chapel Hill, N.C., and an enrolled agent licensed to practice before the Internal Revenue Service. The author may be contacted at phaggerty@prodigy.net.

Do you have a question for Payroll in Practice? Send it to phaggerty@prodigy.net.

To contact the editor on this story: William Dunn at wdunn@bloombergindustry.com