The paid for or incurred rule depends in part upon whether your business uses the cash or accrual accounting method. You would record transactions as they occur instead of when they’re paid if you use the accrual method.
Cash vs. Accrual Method for Tax-Deductible Expenses
You must claim the tax deduction for salaries, wages, commissions, and bonuses in the year they’re paid to your employees if your business uses the cash method of accounting. You would claim the deduction for the year in which the obligation to pay is established and when the services are actually performed if you use the accrual method. This is the case even if the funds are actually disbursed later. Most companies pay salaries in cash rather than in goods or services. The deduction is usually the fair market value of the goods or services transferred if you render non-cash compensation.
Salaries and Wages Must Be Deemed Reasonable
Salaries and wages generally aren’t challenged by the IRS as being unreasonable unless the employee has some leverage over you. This might be the case if your employee is a large investor or has a personal relationship with you. The IRS deems compensation as being reasonable “if the amount would ordinarily be paid for like services by like enterprises under like circumstances.” Reasonableness is based on all the associated facts and circumstances, according to the IRS.
Is Your Compensation Tax-Deductible?
The tax consequences of compensation that’s paid to you as the business owner should be evaluated separately from the salary and wages you pay to your employees. You can’t claim a business expense deduction for amounts you receive from the business if you’re a sole proprietorship. The business’ net profits are considered taxable income whether you take the money out of the business or leave it in the business. Self-employment tax applies to the entire amount. Salaries might be paid to some partners or owners if your business is a partnership or an S corporation, but all profits for the year will be taxable to those partners or owners. These are “pass-through” business entities. The income trickles down to be dealt with on their own personal tax returns. Reasonableness is not an issue in this case. Many factors and variables are open to interpretation when you’re reporting tax deductions. Understanding that you can report certain activities as deductions is key to using tax laws to your advantage.
What Other Compensations Are Tax-Deductible?
Other types of payments also qualify under the salary and wage category. They include awards, bonuses, sick leave, vacation pay, education expenses, reimbursements, and loans to employees.
