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ComplianceLegalFinanceJanuary 13, 2021

Understanding the tax consequences of compensation

As a general rule, you can claim a tax deduction for the salary, wages, commissions, bonuses, and other compensation that you pay to your employees, provided the payments meet the following requirements. The compensation must 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 you use the the cash or accrual method of accounting.

Cash method taxpayers must claim the deduction for the salary, wage, or benefit payment in the year it's paid to the employee. Accrual method taxpayers claim the deduction for the year in which the obligation to pay is established and when the services are performed, even if the actual paycheck is distributed later.

Most employers pay their employees in cash, rather than in goods or services. However, if you do provide non-cash compensation (other than fringe benefits that are subject to their own rules), then the amount you can deduct is generally the fair market value of the property transferred.

Compensation must be reasonable

Reasonable compensation is a "hot button" issue with the IRS--particularly with small, family-owned businesses. 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. However, in these situations, the IRS will closely scrutinize the payments. Unfortunately, most small businesses fall squarely into both these situations.

In deciding whether compensation is reasonable, the IRS uses the following definition: compensation is reasonable if that amount "would ordinarily be paid for like services by like enterprises under like circumstances."

This means the IRS will evaluate all the facts and circumstances including the following:

  • Factors related to the employee
    • responsibilities and duties in the organization (his or her importance to the company's success)
    • type and extent of services rendered (hours worked, duties performed)
    • his or her qualifications for the position
    • his or her prior earning capacity
  • Factors related to the company or industry
    • prevailing rate of compensation paid by similar companies in similar industries for similar services.
    • scarcity of qualified employees
    • company's size
    • general economic conditions
  • Factors related to company/employee relationship
  • whether the employee controls the company (allowing him or her to disguise non-deductible corporate distributions of income as deductible compensation)
  • whether the compensation is paid pursuant to a structured, formal, and consistently applied program. Warning: bonuses that are not paid under a formal plan in existence at the beginning of the year are suspect.

Clearly these factors are open to interpretation. And, the IRS and the taxpayer frequently have a very different view of "reasonable." More courts are choosing to frame the issue this way: "would a completely independent investor in the company be willing to pay that level of compensation to this individual?" Viewed in that light, one can see why paying your 12 year old son $7.50/hour for general janitorial services at the office would be considered reasonable, while paying him $75.00/hour would not.

Careful attention must be paid to business owners' compensation

If you operate your business as a sole proprietorship, you can not claim a business expense deduction for amounts you receive from the business. (Of course, you can claim a deduction for any wages paid to employees.) However, all of the net profits of the business are taxable income to the owner, regardless of whether you take the money out or leave it in the business bank accounts. Self-employment tax applies to the entire amount.)

In a partnership or an LLC, some partners or owners may receive salaries (known as guaranteed payments), but all of the business's profits for the year will ultimately be taxable to the partners or owners, so the reasonableness of the compensation is rarely an issue.

Salaries paid by closely held corporations are scrutinized.

Payments made to an employee who is also the owner of the corporation are subject to very close scrutiny by the IRS. For C corporations, this scrutiny is triggered in part because salaries paid to owner/employees is deducted before the corporate income tax is imposed. Any after-tax corporate profits are distributed as dividends to the shareholders and taxed at their individual income tax rates. The difference between the corporate income tax rates and the individual income tax rates sometimes tempts business owners to inflate their salaries to get a larger deduction against the corporate income tax.

However, evading corporate level tax is not the only reason for payments to owners to be closely scrutinized. Payments from both S corporations and C corporations can come under suspicion because low compensation can be a way to avoid employment tax liability.

The IRS also scrutinizes these "related party" payments to see if they aren't really dividends, not compensation. Often, some portion of the salary paid to owner-employees is held to be disguised dividends if a corporation hasn't paid any dividends or has only paid nominal dividends during its existence, and has, at the same time, paid unusually large salaries to employee-owners.

Your corporation doesn't have to issue dividends, but the failure to pay dividends is a significant factor in determining the true nature of the payments. If you have legitimate business reasons for not paying dividends, such as the need to conserve capital for expansion or reinvesting in the business, then make sure those are documented carefully.

Another factor that increases the likelihood of disallowance is a close relationship between salaries and stock holdings. If an employee's salary closely tracks his or her stock holdings, it's strong evidence that the salary is in fact a disguised dividend payment.


You may also want to avoid paying out year-end bonuses determined after the corporate profits for the year are calculated, unless you have a plan in place and clearly document that these bonuses are tied to contribution to the excellent performance.

Documentation and advance planning is critical!

Without a well-documented plan, this type of bonus may arouse suspicion that, rather than being compensation for services, it is actually a distribution of profits.

As a result, the IRS has made a practice of investigating the reasonableness of compensation paid to stockholder/employees in corporations. If your compensation is determined to be out of line, it could be treated as a disguised, nondeductible corporate dividend, and your compensation deduction could be denied.

Therefore, to reiterate what was discussed above under Compensation Must Be Reasonable, any compensation that you receive should be in line with:

  • your personal credentials,
  • compensation paid to non-shareholding employees,
  • your degree of involvement in generating corporate income,
  • the type of work you perform, and
  • the prevailing local rate of compensation for similar expertise and work.

Like Goldilocks porridge, your goal is to make sure your compensation is "just right" -- not too high or too low. Either extreme can result in adverse consequences in an IRS audit.

Know rules for special types of compensation

The rules regarding when you can deduct compensation paid to employees generally are straightforward.

However, there are some types of payments that can present issues regarding when the amounts are considered "paid" and, therefore, deductible. Among these special types of payments are vacation pay, bonuses and advances to employees.

Timing of vacation pay deduction varies by accounting method

If you use the cash method, it's simple: you only deduct what you actually paid to your employees during your tax year, whether you're talking about vacation pay or that last December paycheck.

If you're on the accrual method, you may be able to deduct vacation pay or unpaid salaries before the payment is actually made, so long as the employee's right to the payment is fixed, and unconditional, and the employee has done the work on which the payment is based.

For example, if the employee's pay period ended on December 31 and your paychecks are issued a week later, you could deduct the amount for that last pay period of the year. Accrued vacation pay must be paid within two and one-half months to come under this rule.

There is an exception to the rule for employees who are related to you. If your employee is your spouse, child, brother or sister, parent or grandparent, you may only deduct the payment in the year in which the employee reports the payment as income.

This means that if the recipient is using the cash method (as most individuals do), you may only deduct the vacation pay or unpaid salaries in the year you pay it, after all.

Loans or advances may be deductible

If you make a loan to an employee that you don't expect to be repaid, you can deduct the amount as compensation. If you do expect the loan to be repaid, it would not be deductible unless and until the employee defaults.

If an employee has outstanding loans over $10,000 and you are not charging interest, or you are charging interest at a rate below the applicable federal rate, you may have to report "imputed interest" income at the federal rate, and also report this imputed interest as additional compensation to the employee.

You can find out the current applicable federal interest rate or by calling the IRS at 1-800-TAX-1040. Consult your tax advisor for more information if you think this rule applies to you. You may wish to work with your accountant to make sure that you are using the correct rate.

Awards and bonuses require special treatment

Compensation in the form of awards and bonuses require special tax treatment.

Bonuses. You can deduct the cost of any bonuses you pay to your employees, as long as the bonus represents pay for services rather than a gift, and it's reasonable in view of the employee's services and performance. If you're a cash method taxpayer, you must have paid the bonus before the end of your tax year in order to deduct in that year.

Accrual method taxpayers can deduct the bonus paid to a non-related employee in the tax year in which you established the amount and the employee's right to the bonus. If you use the accrual method, you may be able to deduct a bonus in one tax year if you actually pay it within two and one-half months following the close of the tax year.

If a bonus is paid more than two and one-half months following the close of the employer's tax year in which it was earned, it is presumed to have been paid under a deferred compensation plan or arrangement. Unless the presumption is rebutted, it may not be deducted until it is actually or constructively paid. Therefore, it may not be deducted by an accrual-basis taxpayer in the year in which it was earned.


There is an exception to the accrual bonus rules for related taxpayers: If your bonus-achieving employee is your spouse, child, brother or sister, parent or grandparent, you may only deduct the payment in the year in which the employee reports the payment as income. This means that if the recipient is using the cash method (as most individuals do), you may only deduct the bonus in the year you pay it, after all.

How to deduct compensation paid

How you deduct compensation that you paid to your workers depends upon the type of business that you operate and whether they are employees or independent contractors.

Non-manufacturing businesses. If you are not in a manufacturing business, 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.

Manufacturing businesses. If you are a manufacturer, the wages and benefits of production workers, indirect factory workers, and supervisors must be included in your cost of goods sold computation. These expenses are not deducted directly as business expenses.

Payroll tax reporting. Your payments of payroll taxes such as FICA, FUTA, and state unemployment taxes are reported on Schedule C, Line 23.

Payments to independent contractors are deducted based on type of service

The gross amount you pay to an independent contractor is deductible. However, since an independent contractor is, by definition, not an employee, you will not report these amounts as wages or benefits.


There are a host of special rules that determine which workers can be considered independent contractors and which must be treated as employees.

Failure to properly classify those who perform work for you can expose you to significant fines and penalties! If you are in the slightest doubt as to which category a worker fits, be sure to read our discussion of the independent contractor rules.

You report payments to independent contractors under the category of expenses for which the independent contractor's services were provided.


Dwight paid an independent contractor to perform repairs at his store. He will report those payments under the "repairs" category of expenses. He also paid an paid an independent contractor to create brochures for his company. He reports those expenses under advertising.

Form 1099 required if payments exceed $600. If, in the course of a year, you pay $600 or more to an independent contractor, or you pay $600 or more in rents, services including parts and materials, or attorney fees, you must report the payment on IRS Form 1099-MISC.

Give a copy to the contractor by January 31, and send a copy to the IRS by February 28. These rules generally don't apply to payments made to corporations. (The Saturday, Sunday, holiday rule applies to these dates.)

Form 1099-MISC is a machine-readable form, and you must use the official IRS version (call 1-800-TAX-FORM for a copy) or a pre-approved computer-generated form (software is available in most larger office supply stores).

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