Salaries and Wages as Tax-Deductible Expenses

Other Items May Also Qualify as Salaries and Wages

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Generally speaking, the salaries, wages, commissions and bonuses paid to 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.

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 the 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 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

However, 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.

A full list and explanation of each can be found in IRS Publication 334.

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, perhaps as a large investor, or has a personal relationship with the business owners.

Unfortunately, many small businesses have both these situations, which makes "reasonableness" an area of IRS scrutiny. 

The IRS uses this definition of reasonableness: compensation is deemed reasonable if that 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. A more workable definition may be, "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 to the owner no matter whether you take the money 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, so 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.