Publication 535 (2005), Business Expenses

2. Employees' Pay

Table of Contents

Introduction

You can generally deduct the pay you give your employees for the services they perform. The pay may be in cash, property, or services. It may include wages, or salaries, or other compensation such as: vacation allowances, bonuses, commissions, and fringe benefits. For information about deducting employment taxes, 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.
Welfare-to-work credit.
Work opportunity credit.
Credits for employers affected by Hurricane Katrina, Rita, or Wilma.

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, or Publication 4492, Information for Taxpayers Affected by Hurricanes Katrina, Rita, and Wilma.

Topics - This chapter discusses:

Tests for deducting pay
Kinds of pay

Useful Items - You may want to see:

Publication

15 (Circular E), Employer's Tax Guide
15-A Employer's Supplemental Tax Guide
15-B Employer's Tax Guide to Fringe Benefits

See chapter 14 for information about getting publications and forms.

Tests for Deducting Pay

To be deductible, your employees' pay must be an ordinary and necessary expense and you must pay or incur it. These and other requirements that apply to all business expenses are explained in chapter 1.

In addition, the pay must meet both of the following tests.

Test 1. It must be reasonable.
Test 2. It must be for services performed.

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 both deductible.

Test 1—Reasonableness

Determine the reasonableness of pay by the facts and circumstances. Generally, reasonable pay is the amount that like enterprises would pay for the same, or similar, services.

You must be able to prove that the pay is reasonable. Base this test on the circumstances that exist when you contract for the services, not those that exist when the reasonableness is questioned. If the pay is excessive, you cannot deduct the excess.

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 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 officer's pay. You must base the test of whether an individual officer's pay is reasonable on each individual officer'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.

Test 2—For Services Performed

You must be able to prove the payment was made for services actually performed.

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 to the employee-shareholder. For more information on corporate distributions to shareholders, see Publication 542, Corporations.

Kinds of Pay

Some of the ways you may provide pay to your employees in addition to regular wages or salaries are discussed next. For specialized and detailed information on employees' pay and the employment tax treatment of employees' pay, see Pub. 15, Pub. 15-A, and Pub. 15-B.

Awards

You can generally deduct amounts you pay to your employees as awards, whether paid in cash or property. 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 qualify as a length-of-service award if either of the following applies.

The employee receives the award after his or her first 5 years of employment.
The employee did not receive 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 for safety achievement will qualify as an achievement award unless one 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.

$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 2005 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 $95,000 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, ignore awards of nominal value.

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

Bonuses

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 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 minimus 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.

Education Expenses

If you pay or reimburse education expenses for an employee, you can deduct the payments. Deduct them on the “employee benefit programs” or other appropriate line of your tax return 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.

Fringe Benefits

A fringe benefit is a form of pay for the performance of services. You can generally deduct the cost of fringe benefits.

You may be able to exclude all or part of the value of some fringe benefits from your employees' pay. You also may not owe employment taxes on the value of the fringe benefits. See Table 2-1 in Publication 15-B for details.

Your deduction for the cost of fringe benefits for activities generally considered entertainment, amusement, or recreation, or for a facility used in connection with such an activity (for example, a company aircraft) for certain officers, directors, and more-than-10% shareholders is limited to the amount actually reported as compensation subject to employment taxes. See Pub. 15-B for more information on fringe benefits included as compensation.

The following are examples of fringe benefits.

Benefits under employee benefit programs (defined below).
Meals and lodging.
Use of a car.
Flights on airplanes.
Discounts on property or services.
Memberships in country clubs or other social clubs.
Tickets to entertainment or sporting events.

Employee benefit programs. Employee benefit programs include the following.

Accident and health plans.
Adoption assistance.
Cafeteria plans.
Dependent care assistance.
Educational assistance.
Life insurance coverage.
Welfare benefit funds.

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

Life insurance coverage. You cannot deduct the cost of life insurance coverage for you, an employee, or any person with a financial interest in your business, if you are directly or indirectly the beneficiary of the policy. See Regulations section 1.264-1 for more information.

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, 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. These claims can be 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. Deduct the cost in whatever category the expense falls. For example, if you operate a restaurant, deduct the cost of the meals you furnish to 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.
Meals that qualify as a de minimus 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.

Loans or Advances

You generally can deduct as wages an advance you make to an employee for services performed if you do not expect the employee to repay the advance. However, if the employee performs no services, treat the amount you advanced as a loan. If the employee does not repay the loan, it may be deductible as a bad debt. See chapter 11 for information on the deduction for bad debts.

Below-market interest rate loans. On certain loans you make to an employee or shareholder, you are treated as having received interest income and as having paid compensation or dividends equal to that interest. See Below-Market Loans in chapter 5.

Property

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 the property's fair market value on the date of the transfer less 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. This means that the recipient is not likely to have to give up his or her rights in the property in the future.

Reimbursements for Business Expenses

You can generally deduct the amount you pay or reimburse employees for business expenses incurred for your business. However, your deduction may be limited.

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. If you make the payment under a nonaccountable plan, deduct it as wages.

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

Sick and Vacation Pay

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 employee benefit. It includes amounts paid for unused vacation leave. You can deduct vacation pay only in the tax year in which the employee actually receives it. This rule applies regardless of whether you use the cash or accrual method of accounting.