Publication 535 |
2001 Tax Year |
Tests for Deducting Pay
To be deductible, your employees' pay must be an ordinary and
necessary expense and you must pay or incur it in the tax year. These
and other requirements that apply to all business expenses are
explained in chapter 1.
In addition, the pay must meet both the following tests.
- Test 1. The pay must be
reasonable.
- Test 2. The pay must be for services
performed.
If these tests are met, the form or method of figuring the pay
does not affect its deductibility. For example, bonuses and
commissions based on sales or earnings and paid under an agreement
made before the services were performed are generally deductible.
Employee-shareholder salaries.
If a corporation pays an employee who is also a shareholder a
salary that is unreasonably high considering the services actually
performed, the excessive part of the salary may be treated as a
constructive distribution of earnings to the employee-shareholder. For
more information on corporate distributions to shareholders, see
Publication 542,
Corporations.
Test 1--Reasonable
Determine the reasonableness of pay by the facts. Generally,
reasonable pay is the amount that like enterprises ordinarily would
pay for the services under similar circumstances.
You must be able to prove the pay is reasonable. Base this test on
the circumstances that exist when you contract for the services, not
those existing when the reasonableness is questioned. If the pay is
excessive, you can deduct only the part that is reasonable.
Factors to consider.
To determine if pay is reasonable, consider the following items and
any other pertinent facts.
- The duties performed by the employee.
- The volume of business handled.
- The character and amount of responsibility.
- The complexities of your business.
- The amount of time required.
- The general cost of living in the locality.
- The ability and achievements of the individual employee
performing the service.
- The pay compared with the gross and net income of the
business, as well as with distributions to shareholders if the
business is a corporation.
- Your policy regarding pay for all your employees.
- The history of pay for each employee.
Individual pay.
You must base the test of whether an individual's pay is reasonable
on each individual's pay and the service performed, not on the total
amount paid to all officers or all employees. For example, even if the
total amount you pay to your officers is reasonable, you cannot deduct
the part of an individual officer's pay that is not reasonable based
on the items listed above.
Test 2--For Services Performed
You must be able to prove the payment was made for services
actually performed.
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