Generally speaking, the salaries, wages, commissions, and bonuses you have paid to the employees of your small business are tax-deductible expenses if they are deemed to be:
- Ordinary and necessary
- Reasonable in amount
- Paid for services actually provided
- Paid for or incurred in the current year
The year in which you claim the tax deduction depends in part upon whether your business uses the cash or accrual accounting methods. Under the accrual accounting method, you record transactions as they occur instead of as they are paid.
Cash Methods Versus Accrual Methods
If your business uses the cash method of accounting, you must claim the tax deduction for salaries, wages, commissions, and bonuses in the year it's paid to your employee.
If your business uses the accrual method of accounting, the deduction is claimed for the year in which the obligation to pay is established and when the services are actually performed, even if the funds are actually disbursed later.
While most companies pay salaries in cash, rather than goods or services, if you do render non-cash compensation, then the deduction is usually the fair market value of the goods or services transferred.
Other Compensation That May Be Tax-Deductible
Other items also qualify under the salary and wage category with regard to employee wages. A partial list includes sick leave, vacation pay, education expenses, reimbursements, and a loan to an employee. Awards and bonuses should be considered as well.
Salaries and Wages Must Be Deemed Reasonable
Ordinarily, salaries and wages are not challenged by the IRS as unreasonable unless the employee has some leverage over the employer (e.g., the employee is a large investor or has a personal relationship with you).
The IRS deems compensation is reasonable "if the amount would ordinarily be paid for like services by like enterprises under like circumstances."
Thus, it is not unusual for the taxpayer and the IRS to have differing views of reasonable compensation. To address these differing views, determine if compensation is competitive across the industry you operate in.
Business Owners' Compensation
The tax consequences of compensation paid to business owners should be evaluated separately.
In sole proprietorships, you cannot claim a business expense deduction for amounts you receive from the business. The business' net profits are considered taxable income whether you take the money out of the business or leave it in the business. Self-employment tax applies to the entire amount.
If your business is a partnership or an LLC, salaries may be paid to some partners or owners (e.g., guaranteed payments) but all profits for the year will be taxable to the partners or owners. In this case, reasonableness is not an issue.
Many factors and variables are open to interpretation when reporting tax deductions. Understanding that you can report certain activities as deductions is key to using tax laws to your advantage. For information specific to your business, you should seek the counsel of accounting and tax professionals.