Deductibility of Pay

You generally can deduct salaries, wages, and other forms of pay you make to employees for personal services as a business expense. However, you must reduce the deduction by any current tax year employment credits. For more information about these credits, see Form 3800 and the related employment credit forms.

Commissions. Generally, you can deduct a commission you pay to a salesperson or another person. However, you and the service provider must agree on the service to be performed and the amount to be paid before that person performs the service.

Employee-stockholder. A salary paid to an employee who is also a stockholder must meet the same tests for deductibility as the salary of any other executive or employee. SeeTests for Deductibility, later.

You cannot deduct a payment to an employee-stockholder that is not for services performed. The payment may be a distribution of dividends on stock. This is most likely to occur in a corporation with few shareholders, practically all of whom draw salaries. A salary paid to an employee-stockholder that is more than the salary ordinarily paid for similar services and that bears a close relationship to the employee's stock holdings probably is not paid wholly for services performed. This salary may include a distribution of earnings on the stock.

If the payment to an employee-stockholder of a closely held corporation is reasonable and for services performed, the payment will not be denied as a deduction merely because the corporation has a poor history of paying dividends on its outstanding stock.

If your corporation uses an accrual method of accounting and the salary is unpaid at the end of the tax year, see Unpaid Salaries, later.

Relative. You can deduct the salary or wages paid to a relative who is an employee, including your minor child, if the payment meets the four tests for deductibility, discussed later. However, also see Unpaid Salaries, later.

Payment to beneficiary of deceased employee. You can deduct a payment you make to an employee's beneficiary because of the employee's death if the payment is reasonable in relation to past services performed by the employee. The payment also must meet the other tests for deductibility, discussed later.

Uniform capitalization rules. Generally, you must capitalize or include in inventory the wages and salaries you pay employees to produce real or tangible personal property or to acquire property for resale. If the property is inventory, add the wages to inventory. Capitalize the costs for any other property.

Personal property you acquire for resale is not subject to these rules if your average annual gross receipts for the 3 preceding tax years are $10 million or less. You can deduct these costs as a current business expense. For more information, see Publication 551.

Construction of capital asset. You cannot deduct salaries and other wages incurred for constructing a capital asset. You must include them in the basis of the asset and recover your cost through depreciation deductions. See Publication 946 for information about depreciation.

Tests for Deductibility

To be deductible, salaries or wages you pay your employees must meet all the following tests.

òOrdinary and necessary òReasonable òFor services performed òPaid or incurred

Test 1 -- Ordinary and necessary. You must be able to show that the salary, wage, or other payment for services an employee performs for you is an ordinary and necessary expense. You also must be able to show that it is directly connected with your trade or business. For more information, seen What Can Be Deducted? in chapter 1.

That you pay your employee for a legitimate business purpose is not sufficient, by itself, for you to deduct the amount as a business expense. You can deduct a payment for your employee's services only if the payment is ordinary and necessary to carry on your trade or business.

Expenses (including salaries and other payments for services) incurred to complete a merger, recapitalization, consolidation, or other reorganization are not expenses of carrying on a business; they are capital expenditures. You cannot deduct them as ordinary and necessary business expenses. However, if you later abandon your plan to reorganize, etc., you can deduct the expenses for the plan in the tax year you abandon it.

Test 2 -- Reasonable. Determine the reasonableness of pay by the facts. Generally, reasonable pay is the amount that like enterprises ordinarily would pay for the services by like enterprises under similar circumstances.

You must be able to prove the pay is reasonable. Base this test on the circumstances that exist at the time you contract for the services, not those existing when the reasonableness is questioned. If the pay is excessive, you can deduct only the part that is reasonable.

Factors to consider. To determine if pay is reasonable, consider the following items and any other pertinent facts.

òThe duties performed by the employee. òThe volume of business handled. òThe character and amount of responsibility. òThe complexities of your business. òThe amount of time required. òThe general cost of living in the locality. òThe ability and achievements of the individual employee performing the service. òThe pay compared with the amount of gross and net income of the business, as well as with distributions to shareholders, if the business is a corporation. òYour policy regarding pay for all of your employees. òThe history of pay for each employee.

Individual salaries. You must base the test of whether a salary is reasonable on each individual's salary and the service performed, not on the total salaries paid to all officers or all employees. For example, even if the total amount you pay to your officers is reasonable, you cannot deduct an individual officer's entire salary if it is not reasonable based on the items listed above.

Test 3 -- For services performed. You must be able to prove the payment was made for services actually performed.

Test 4 -- Paid or incurred. You must have actually made the payment or incurred the expense in the tax year.

If you use the cash method of accounting, deduct the salary or wages paid to an employee in the year you pay it to the employee.

If you use an accrual method of accounting, deduct your expense for the salary or wage when you establish your obligation to make the payment and when economic performance occurs. Economic performance generally occurs as an employee performs the services for you. The economic performance rule is discussed in When Can an Expense Be Deducted? in chapter 1. Your payment need not be made in the year the obligation exists. You can defer it to a later date, but special rules apply. See Unpaid Salaries, later.

Employees' Pay

You can generally deduct salaries, wages, and fringe benefits you pay to your employees for their services on Schedule C. You can also deduct amounts you pay for your employees to employee benefit programs.

You can deduct salaries or wages if they are:

1.Ordinary and necessary, 2.Reasonable, 3.For services performed, and 4.Paid or incurred.

Chapter 2 in Publication 535 explains and defines these requirements.

You cannot deduct your own salary or any personal withdrawals you make from your business. You are not an employee of the business.

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If you had employees during the year, you must use Schedule C. You cannot use Schedule C-EZ.

Some of the payments you may be able to deduct are listed below. For an explanation of each of these items, see chapter 2 in Publication 535.

òBonuses. òGifts of nominal value, such as turkeys and hams. òEmployee achievement awards that meet certain requirements. òLoans or advances that you do not expect the employee to repay if they are for personal services actually performed. òVacation pay. òCompensation for sickness and injury. òCost of furnishing meals and lodging to employees. òReimbursements for employee business expenses. òEducational expenses. òMoving expenses. òA capital asset or business asset that you transfer to one of your employees as payment for services.

Fringe benefits. A fringe benefit is a form of pay provided to any person for the performance of services by that person. You can deduct the cost of fringe benefits you provide. However, you must include in your employees' pay the value of fringe benefits you provide unless the benefits are specifically excluded from income by law or the employee pays for them. The following are examples of fringe benefits.

òThe use of a car. òA flight on an airplane. òA vacation. òA discount on property or services. òA membership in a country club or other social club. òA ticket to an entertainment or sporting event.

For information on the rules that apply to fringe benefits, see chapter 4 in Publication 535. That chapter explains how to value fringe benefits and determine whether fringe benefits are excludable from your employees' incomes.

Employee benefit programs. You can generally deduct amounts you spend on employee benefit programs as a business expense. You can also exclude from an employee's income the value of part or all of the benefits you provide. Employee benefit programs include the following.

òAdoption assistance. òCafeteria plans. òDependent care assistance. òEducational assistance. òGroup-term life insurance. òGroup health plans (including medical savings accounts). òWelfare benefit funds.

Adoption assistance program. An adoption assistance program is a separate written plan you set up to provide adoption assistance to your employees. You can deduct the cost of an adoption assistance program you provide for your employees on Schedule C.

Up to $5,000 ($6,000 for a special needs child) you pay or incur under an adoption assistance program for an employee's qualified adoption expenses is excludable from the employee's gross income. For more information on this exclusion, including the definitions of the terms "special needs child" and "qualified adoption expenses," see Publication 968, Tax Benefits for Adoption.

Medical savings accounts. You may be able to open a medical savings account (MSA) for yourself and each of your employees if you had on average 50 or fewer employees in either of the 2 preceding calendar years and have a high deductible health plan. You can deduct the contributions you make to MSAs for yourself and your employees. You open the MSA with a trustee or custodian, such as a bank or insurance company. For more information about MSAs, get Publication 969.

More information. For more information about employee benefit programs, see chapter 5 in Publication 535. That chapter explains what costs you can deduct and which part of the benefits you can exclude from an employee's income.