Salaries and Wages as Tax-Deductible Expenses
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, and
- Actually paid or incurred in the year for which you claim the deduction
The year in which you claim the deduction depends, in part, upon whether your business uses the cash or accrual accounting methods.
Cash Methods Versus Accrual Methods
If your business uses the cash method of accounting, you must claim the 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, and reimbursements. A loan to an employee that you don't expect to be repaid, may also be tax-deductible. However, awards and bonuses should be considered individually.
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). Unfortunately, many small businesses experience both of these situations, which makes "reasonableness" an area of IRS scrutiny.
The IRS uses the following definition of reasonable compensation: "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. A more workable standard would be how you answer the following question: "Would a completely independent investor in the company be willing to pay that level of compensation to this individual?"
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.
Clearly, many factors and variables are open to interpretation, and you should seek the counsel of accounting and tax professionals.