Deductible Compensation and Benefits

As a general rule, a business can claim a tax deduction for the salary, wages, commissions, bonuses, and other compensation it pays to its employees. To be deductible, the compensation must be ordinary and necessary, reasonable in amount, based on services rendered, and actually paid or incurred in the year for which the deduction is claimed (as shown by your payroll records.)

The timing of your deduction will depend on whether you use the cash or accrual method of accounting. If you use the cash method, you must deduct your expense for the salary, wage, or benefit payment in the year it's paid to the employee. If you use the accrual method, you must generally deduct the expense when you establish your obligation to make the payment and when the services are performed, even if the actual paycheck is distributed later.

If the compensation is paid in some form other than cash, the deductible amount is generally equal to the fair market value of the property transferred. For example, if you give your employees gold-plated widgets, as an end-of-the-year bonus, the cost you paid for the widgets would be deductible.

What is "reasonable" compensation to employees depends on the facts and circumstances at the time the compensation is paid. Ordinarily, the IRS will not challenge the amount of the compensation as unreasonable unless the employee has some control over the employer (e.g., is a large stockholder) or has some personal relationship with the owners.

Sole proprietors' deductions for wages and benefits. For sole proprietors who are not in a manufacturing business, the value of wages and salaries you pay to your employees is reported on Line 26 of Schedule C. Payments for employee benefit plans are reported separately. Retirement plan contributions are reported on Line 19, and your contributions for all other employee benefit plans are reported on Line 14.

However, if you are a manufacturer, the wages and benefits of production workers, indirect factory workers, and supervisors must be included in your cost of goods sold, computation and are not deducted again as business expenses.

Finally, your payments of payroll taxes such as FICA, FUTA, and state unemployment taxes are reported on Schedule C, Line 23.

Questions about the deductibility of compensation most often arise in the following situations:

• Compensation for owners is reported differently, depending on the type of business you have. In a C corporation, each owner/employee's salary must be reasonable, or the IRS may treat some or all of the salary as a nondeductible dividend.
• Benefits and perks for the business owner and his or her family can draw IRS attention if they are too generous or don't meet tax law requirements.
• The deductible cost of employee benefits or payments may differ from the value of the benefit that is taxable to the employee.
• If you reimburse employees for expenses such as travel, meals and entertainment, or automobile expenses, there are some rules you need to know about.
• If you use independent contractors, you can deduct the payments but have some special reporting obligations.