Publication 535: Business Expenses; Employees' Pay

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Table of Contents

Introduction

You can generally deduct the pay you give your employees for the services they perform for your business. The pay may be in cash, property, or services. It may include wages, salaries, vacation allowances, bonuses, commissions, and fringe benefits. This chapter provides information about deductions allowed for various kinds of pay.

For information about determining who is an employee and about employment taxes on your employees' pay, see Publication 15, Circular E, Employer's Tax Guide, Publication 15–A, Employer's Supplemental Tax Guide, and Publication 15–B, Employer's Tax Guide to Fringe Benefits. For information about deducting employment taxes paid on your employees' pay, see chapter 6.

You can claim the following employment credits if you hire individuals who meet certain requirements.

Empowerment zone and renewal community employment credit.
Indian employment credit.
New York Liberty Zone business employee credit.
Welfare-to-work credit.
Work opportunity credit.

However, you must reduce your deduction for employee wages by the amount of any employment credits you claim. For more information about these credits, see Publication 954, Tax Incentives for Distressed Communities.

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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.

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.

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.

You can generally deduct amounts you pay to your employees as awards, whether paid in cash or property. (For awards paid in property, see Property, later.) If you give property to an employee as an employee achievement award, your deduction may be limited.

Achievement awards.

An achievement award is an item of tangible personal property that meets all the following requirements.

It is given to an employee for length of service or safety achievement.
It is awarded as part of a meaningful presentation.
It is awarded under conditions and circumstances that do not create a significant likelihood of disguised pay.

Length-of-service award.

An award will not qualify as a length-of-service award if either of the following applies.

The employee receives the award during his or her first 5 years of employment.
The employee received another length-of-service award (other than one of very small value) during the same year or in any of the prior 4 years.

Safety achievement award.

An award will not qualify as a safety achievement award if either of the following applies.

It is given to a manager, administrator, clerical employee, or other professional employee.
During the tax year, more than 10% of your employees, excluding those listed in (1), have already received a safety achievement award (other than one of very small value).

Deduction limit.

Your deduction for the cost of employee achievement awards given to any one employee during the tax year is limited to the following amounts.

$400 for awards that are not qualified plan awards.
$1,600 for all awards, whether or not qualified plan awards.

Deduct achievement awards as a nonwage business expense on your return or business schedule.

A qualified plan award is an achievement award given as part of an established written plan or program that does not favor highly compensated employees as to eligibility or benefits.

A highly compensated employee for 2003 is an employee who meets either of the following tests.

The employee was a 5% owner at any time during the year or the preceding year.
The employee received more than $90,000 in pay for the preceding year.

You can choose to ignore test (2) if the employee was not also in the top 20% of employees ranked by pay for the preceding year.

An award is not a qualified plan award if the average cost of all the employee achievement awards given during the tax year (that would be qualified plan awards except for this limit) is more than $400. To figure this average cost, do not take into account awards of very small value.

You may not owe employment taxes on the value of achievement awards you provide to an employee. See Publication 15–B.

You can generally deduct a bonus paid to an employee if you intended the bonus as additional pay for services, not as a gift, and the services were actually performed. However, the total bonuses, salaries, and other pay must be reasonable for the services performed. If the bonus is paid in property, see Property, later.

Gifts of nominal value.

If, to promote employee goodwill, you distribute turkeys, hams, or other merchandise of nominal value to your employees at holidays, you can deduct the cost of these items as a nonwage business expense. Your deduction for de minimis gifts of food or drink are not subject to the 50% deduction limit that generally applies to meals. For more information on this deduction limit, see Meals and lodging, later.

If you pay or reimburse education expenses for an employee, you can deduct the payments. Deduct the payments on the “employee benefit programs” line of your tax return or business schedule if they are part of a qualified educational assistance program. For information on educational assistance programs, see Educational Assistance in section 2 of Publication 15–B.

A fringe benefit is a form of pay provided to any person for the performance of services by that person. The following are examples of fringe benefits.

You can generally deduct the cost of fringe benefits you provide on your tax return or business schedule in whatever category the cost falls. For example, if you allow an employee to use a car or other property you lease, deduct the cost of the lease as a rent or lease expense. If you own the property, include your deduction for its cost or other basis as a section 179 deduction or a depreciation deduction.

You may not owe employment taxes on the value of the fringe benefits you provide to an employee. See Publication 15–B.

Employee benefit programs.

Employee benefit programs include the following.

Accident and health plans.
Adoption assistance.
Cafeteria plans.
Dependent care assistance.
Educational assistance.
Group-term life insurance coverage.
Welfare benefit funds.

You can generally deduct amounts you spend on employee benefit programs on the “employee benefit programs” line of your tax return or business schedule. However, you may deduct certain costs on other lines. For example, if you provide dependent care by operating a dependent care facility for your employees, deduct your costs in whatever categories they fall (depreciation, utilities, salaries, etc.).

Welfare benefit funds.

A welfare benefit fund is a funded plan (or a funded arrangement having the effect of a plan) that provides welfare benefits to your employees, independent contractors, or their beneficiaries. Welfare benefits are any benefits other than deferred compensation or transfers of restricted property.

Your deduction for contributions to a welfare benefit fund is limited to the fund's qualified cost for the tax year. If your contributions to the fund are more than its qualified cost, you can carry the excess over to the next tax year.

Generally, the fund's qualified cost is the total of the following amounts, reduced by the after-tax income of the fund.

The cost you would have been able to deduct using the cash method of accounting if you had paid for the benefits directly.
The contributions added to a reserve account that are needed to fund claims incurred but not paid as of the end of the year for supplemental unemployment benefits, severance pay, or disability, medical, or life insurance benefits.

For more information, see sections 419(c) and 419A of the Internal Revenue Code and the related regulations.

Meals and lodging.

You can usually deduct the cost of furnishing meals and lodging to your employees. However, you can generally deduct only 50% of the cost of furnishing meals.

Deduct the cost on your tax return or business schedule in whatever category the expense falls. For example, if you operate a restaurant, deduct the cost of the meals you furnish to your employees as part of the cost of goods sold. If you operate a nursing home, motel, or rental property, deduct the cost of furnishing lodging to an employee as expenses for utilities, linen service, salaries, depreciation, etc.

Deduction limit on meals.

You can generally deduct only 50% of the cost of furnishing meals to your employees. However, you can deduct the full cost of the following meals.

Meals whose value you include in an employee's wages. For more information, see section 2 in Publication 15–B.
Meals that qualify as a de minimis fringe benefit as discussed in section 2 of Publication 15–B. This generally includes meals you furnish to employees at your place of business if more than half of these employees are provided the meals for your convenience.
Meals you furnish to your employees at the work site when you operate a restaurant or catering service.
Meals you furnish to your employees as part of the expense of providing recreational or social activities, such as a company picnic.
Meals you are required by federal law to furnish to crew members of certain commercial vessels (or would be required to furnish if the vessels were operated at sea). This does not include meals you furnish on vessels primarily providing luxury water transportation.
Meals you furnish on an oil or gas platform or drilling rig located offshore or in Alaska. This includes meals you furnish at a support camp that is near and integral to an oil or gas drilling rig located in Alaska.

You generally can deduct as wages a loan or advance you make to an employee that you do not expect the employee to repay if it is for personal services actually performed. The total must be reasonable when you add the loan or advance to the employee's other pay. However, if the employee performs no services, treat the amount you advanced to the employee as a loan, which you cannot deduct unless it becomes a bad debt. For information on the deduction for bad debts, see chapter 11.

If you transfer property (including your company's stock) to an employee as payment for services, you can generally deduct it as wages. The amount you can deduct is its fair market value on the date of the transfer minus any amount the employee paid for the property.

You can claim the deduction only for the tax year in which your employee includes the property's value in income. Your employee is deemed to have included the value in income if you report it on Form W–2 in a timely manner.

You treat the deductible amount as received in exchange for the property, and you must recognize any gain or loss realized on the transfer. Your gain or loss is the difference between the fair market value of the property and its adjusted basis on the date of transfer.

A corporation recognizes no gain or loss when it pays for services with its own stock.

These rules also apply to property transferred to an independent contractor, generally reported on Form 1099–MISC.

Restricted property.

If the property you transfer for services is subject to restrictions that affect its value, you generally cannot deduct it and do not report gain or loss until it is substantially vested in the recipient. However, if the recipient pays for the property, you must report any gain at the time of the transfer up to the amount paid.

“Substantially vested” means the property is not subject to a substantial risk of forfeiture. The recipient is not likely to have to give up his or her rights in the property in the future.

You can generally deduct the amount you pay or reimburse employees for business expenses they incur for you for items such as travel and entertainment. However, your deduction for meal and entertainment expenses is usually limited to 50% of the payment.

If you make the payment under an accountable plan, deduct it in the category of the expense paid. For example, if you pay an employee for travel expenses incurred on your behalf, deduct this payment as a travel expense on your tax return or business schedule. See the instructions for the form you file for information on which lines to use.

If you make the payment under a nonaccountable plan, deduct it as wages on your tax return or business schedule.

See Travel, Meals, and Entertainment in chapter 13 for more information about deducting reimbursements and an explanation of accountable and nonaccountable plans.

You can deduct amounts you pay to your employees for sickness and injury, including lump-sum amounts, as wages. However, your deduction is limited to amounts not compensated by insurance or other means.

Vacation pay is an amount you pay to an employee while the employee is on vacation. It includes an amount you pay an employee for unused vacation leave. Vacation pay does not include any sick pay or holiday pay.

You can deduct vacation pay only in your tax year in which the employee actually receives it. This rule applies regardless of whether you use the cash method or an accrual method of accounting.