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 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, "taxes and licenses."

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, some good references are the Business Owner's Toolkit and the IRS's free Publication 15, Employer's Tax Guide.

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.