Tax Implications of Employee Compensation Package to the Employer
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. However, compensation paid to business owners may be subject to serious scrutiny by the IRS.
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.
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.
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.