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 salaries. You must base the test of whether a salary is reasonable on each individual's salary and the service performed, not on the total salaries paid to all officers or all employees. For example, even if the total amount you pay to your officers is reasonable, you cannot deduct an individual officer's entire salary if it 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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