Guide to Deductible Business Expenses | Part 6: Employee Wages
If you’ve been following our blog for a while, you may have already read the first five posts in our series on deductible business expenses. If not, you can check them out at the links below:
Can I deduct my employees’ salaries as a business expense?
Yes. If you run your own business, you may be able to claim a 100% tax deduction for the salaries, wages, commissions, and bonuses paid to your employees during the year. Employers are generally able to deduct employee pay as a business expense if the pay meets the following requirements:
It is an ordinary and necessary expense.
It is paid or incurred during the tax year.
It is reasonable as defined by the IRS.
It is given in exchange for services performed for your business.
Any employee pay you deduct as a business expense must be recorded as income on an employee’s W-2 form, including cash tips, bonuses, commissions, or other form of compensation.
What qualifies employee pay as an “ordinary and necessary” business expense?
The IRS considers business expenses to be “necessary” if they are helpful and appropriate for your business; “ordinary” expenses are generally accepted and commonplace in your field of business. Any business expense must meet these criteria to be eligible for a tax deduction.
How does the IRS define “reasonable” pay?
In addition to being ordinary and necessary as defined by the IRS, employee pay must be considered “reasonable.” Employee pay is deemed reasonable if a similar business would pay the same amount for the same or similar services.
If an employee’s pay exceeds what would be considered reasonable by the IRS, the excess compensation is not eligible for deduction. If an employee-shareholder of a corporation receives unreasonably high compensation, the excess pay may be treated as a dividend for tax purposes. Because dividends are not considered a business expense, the corporation would be ineligible to deduct this excess portion of the employee compensation.
If your business is a publicly-held corporation, you may not deduct employee compensation in excess of $1 million paid to any employee classified as a “covered employee.” Covered employees typically include the top five highest-paid executives of a company, even if their compensation meets the standards of ordinary and reasonable pay. Contact your CPA if you have questions about your organization’s covered employees or compensation deduction limitations.
Can I deduct the cost of hiring a freelancer or independent contractor for my business?
Absolutely. An organization may enlist help from outside professionals for a number of reasons; perhaps your business is in need of legal services, a niche consultant, web design services, plumbing repair, or some other purpose.
In order to deduct the cost of contract labor as a business expense, compensation for the work performed must meet the same criteria governing deductible employee wages; independent contractor fees are considered tax-deductible as long as the compensation is considered ordinary and reasonable.
To claim a business deduction for payment made to an independent contractor, you’ll need to provide them with a 1099-NEC form reflecting how much you paid them in exchange for their work.
As a business owner, can I deduct my own salary?
Possibly, depending on your business structure.
If your business is classified as a sole proprietorship, partnership, or LLC, you are not considered an employee and therefore cannot pay yourself a salary. For tax purposes, the IRS views your business as an extension of you, the owner, rather than as a separate entity; accordingly, all profit earned by your business is considered personal income and reported as such on your personal tax return. Therefore, you cannot deduct payment to yourself as a business expense.
If your business is a corporation, you may be able to deduct your salary as a business expense depending on the type of corporate structure of the business. C corporations (C corps) are considered distinct tax-paying entities by the IRS and are therefore required to pay corporate income taxes. Because C corps are taxed separately from their owners, salaries paid to owners are deductible as a business expense.
Can I deduct employee fringe benefits such as paid sick leave and employee benefit programs as a business expense?
Yes, with some limitations. In addition to deducting employee pay, you may be able to deduct the cost of additional benefits for employees such as paid sick leave, vacation pay, airplane flights, personal use of a company vehicle, employee discounts, and more. The IRS considers such perks a form of pay in exchange for the services provided by your employees.
Most fringe benefits are considered partially or completely tax-deductible. This includes cash bonuses and awards, which must be reported as taxable income on the employee’s W-2.
What about stock options?
That’s a tricky one. Providing shares of company stock has proven a highly effective incentive for many employers, but the tax rules surrounding employee stock options are quite complex. If you have a question about tax treatment for your business’s employee stock options, contact your CPA. Keep an eye out for a future blog post about this topic!
Have more questions about deducting employee pay as a business expense?
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