Deductible Employee Compensation

Compensation you pay to your employees can take many forms. In general, most types of compensation are fully deductible by you. Deductible compensation includes the more common forms, such as salary, wages, bonuses for services performed, vacation pay, sick pay (not otherwise paid by insurance), and fringe benefits, whether or not they are tax-free to your employee. The deduction for these items must be reduced, however, by any employment tax credits claimed. These tax credits are discussed later in this chapter. The timing of when to deduct year-end bonuses paid after the end of the year is discussed in Chapter 2.

General Rules for Deductibility of Compensation

To be deductible, compensation must meet 5 tests. Test 1 requires the compensation be an ordinary and necessary business expense. The payments must be directly connected to the conduct of your business and they also must be necessary for you to carry on your business.

Ordinary and necessary business expense
An ordinary expense is one that is common and accepted in your business. A necessary expense is one that is helpful and appropriate to your business.

For test 2, the compensation must be reasonable. For most employees, this issue never comes up; it is assumed that pay to rank-and-flle employees is reasonable. The question of reasonableness typically arises in connection with pay to owners and top executives. There are no absolute guidelines for determining what is reasonable—it ...

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