• The U.S. government has a few rules and specific tax laws on incentive payments.pay back image by Lars Christensen from Fotolia.com
  
  Incentive pay refers to any compensation paid in addition to any base pay such as commission, early retirement incentives, moving expenses and performance bonus. Federal law generally allows incentive pay by private businesses, though employees must still pay income taxes on incentive pay. Federal law also limits incentive pay in a few narrow circumstances and authorizes early retirement bonuses by government agencies.
  
  

Income Tax

• The Internal Revenue Service calls these additional incentive payments, "supplemental" wages to distinguish them from "regular" hourly or salary-based wages paid for actual work performed. A 2007 ruling from the IRS addressed nine scenarios discussing common supplemental pay situations and how to withhold taxes. In most cases, the employer may either withhold a flat 25 percent plus any state and local taxes. The IRS will later refund any overpayment based on actual tax bracket. Employers may also opt for the aggregate method in which the bonus is counted as part of a regular paycheck and taxes are withheld based on the employer's regular tax bracket. In some scenarios, such as cases where commissions represent an employee's total income, employers must use the aggregate method. IRS rules also mandate a 35 percent flat withholding for any bonus exceeding $1 million.
  
  

TARP Rules

• In response to criticism of multimillion bonus packages paid to executives of troubled financial institutions, President Barack Obama directed the Department of Treasury to revise its rules on government bailouts. Under the new Treasury rules, any company, including automobile manufacturers, accepting money from the Troubled Assets Relief Program (TARP) shall not pay employees more than $500,000 per year including bonuses. The rule only applied to companies taking money after Treasury announced the rule in February 2009. Companies that repay the TARP money no longer have to adhere to the rule.
  
  

Federal Grants

• Federal law generally prohibits incentive pay for projects funded by federal grants. Federal grants often pay for salaries for work performed on the grant-funded research and development project at universities, hospitals and other nonprofit organizations. Thus, these institutions cannot expense incentive pay to federal grants.
  
  

Bankruptcy and Incentive Pay

• Companies looking to emerge from bankruptcy sometimes find it necessary to pay bonuses to retain employees. In such cases, the company will have to ask the bankruptcy judge to allow incentive payments. Nortel, for example, asked a judge in 2009 to allow $45 million in payments to executives and key employees to retain them even as they prepared to lay off 3,200 employees.
  
  

Federal Early Retirement Incentives

• Federal law allows federal agencies and the military to offer a Voluntary Separation Incentive Payment (VSIP), or "buyouts" of up to $25,000 to any employee about to be affected by downsizing or reorganization plans. Under a VSIP, employees may take the money in exchange for retiring or resigning, thus reducing the number of federal government layoffs. Most agencies must follow procedures established by the Office of Personnel Management (OPM), though the Department of Defense has its own VSIP authorization and does not have to seek OPM authorization to offer buyouts.