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. In fact, if you have employees, it's likely
that your deductions for employee compensation will be one of your
largest deductible expenses.
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.
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,
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 capitalized and included in your cost of goods sold, computation and are
not also deducted as business expenses.
Finally, your payments
of payroll taxes such as FICA, FUTA, and state unemployment taxes
are reported on Schedule C, Line 23, "taxes and licenses."
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Warning You should be aware that if you have
employees, you will have some additional tax obligations because of
them. You'll need to withhold and/or pay federal, state, and perhaps
local income taxes; Social Security and Medicare taxes; federal and
state unemployment taxes; and, in some states, disability insurance
taxes. All of these payroll taxes must be paid over to the various
government agencies, along with employment tax returns; for small
employers this is generally done on a quarterly basis. You'll also
need to give each employee a W-2 form at the end of the year, detailing
their pay and the amounts deducted. Payroll tax reporting
is beyond the scope of this Guide. For more information, see the
IRS's free Publication 15, Employer's
Tax Guide. |
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More details on compensation. 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.
- 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.
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