Employer Deductions for Compensation
Compensation is the value given to a worker in exchange for services rendered. Most compensation consists of the payment of money, but may also include fringe benefits or even property. Taxes must be withheld on payments to employees, including federal, state, local, and Social Security and Medicare taxes — otherwise known as FICA (Federal Insurance Contributions Act) or payroll taxes. The employer must also pay ½ of each employee's FICA taxes, equal to 7.65% of the employee's pay and federal and state unemployment taxes. Both compensation and taxes assessed on compensation are deductible by the employer. Fringe benefits can be deducted by the employer even if they are tax-free to the employee. Special rules apply to the deductibility of employee stock options. The taxation of fringe benefits and cafeteria plans are discussed elsewhere.
Business Profits and Compensation
Business owners of sole proprietorships and pass-through entities — partnerships, limited liability companies (LLCs), and S corporations — receive business profits for their efforts. Profit is not considered compensation in regards to tax law and is not deductible by the business. However, for the self-employed, profits are subject to self-employment tax, but the self-employed must pay both the employer portion and the employee portion. Because they can deduct the employer percentage from the amount of taxable income, they only have to pay about 14.13% in self-employment tax instead of the 15.3% that equals the percentage of income that must be paid by both the employer and the employee. The percentage of profits received by partners, LLC members, or S corporation shareholders are also considered self-employment income. However, guaranteed payments, which are payments to partners or LLC members for providing specific services that is not related to the profitability of the business entity is treated as compensation and can be deducted by the entity. S corporation shareholders also receive a distribution of profits, but they can also receive dividends, which are not subject to payroll taxes.
A C corporation is a separate taxable entity, so it must pay taxes on all its income earned during the tax year, whether or not some or all the profits are distributed to shareholders. Distributions to shareholders are always in the form of dividends, which are also not subject to payroll tax, but both the corporation and the shareholders each pay tax on the dividend, thus subjecting it to double taxation. To minimize taxes, owner-employees of closely held C corporations take most of their income in the form salary rather than dividends, so that the C corporation can deduct the full amount as compensation. However, tax law limits the deductibility of compensation paid to top executives of public corporations to $1 million, or $500,000 in the case of medical insurance companies and companies directly benefiting from the Emergency Economic Stabilization Act. Furthermore, if the IRS deems that the amount of compensation is not reasonable, then it may recharacterize the compensation as a constructive dividend, thus forcing the corporation to recognize the dividend amount as additional income, even though the shareholder must still pay taxes on the amount. To minimize this double taxation, some corporations provide disallowance repayment agreements, which are written agreements that require the shareholder to pay back amounts deemed a constructive dividend, which allows the shareholder to deduct the repayment. However, a disadvantage of disallowance repayment agreements is that the amount must be deducted as a miscellaneous itemized deduction by the owner-employee and even having such agreements alerts the IRS that the compensation paid may be unreasonable.
Because taxes on dividends are only paid by the shareholders of an S corporation, there is no double taxation of the dividends and it is not subject to payroll tax, so owner-employees of S corporations generally try to minimize compensation and maximize dividends. However, the IRS requires that compensation paid to S corporation shareholders must be reasonable and comparable to what employees are getting paid in other companies doing the same type of work; otherwise, the income will be recharacterized as compensation for which the owner-employees will be personally liable.
The new tax package passed by the Republicans at the end of 2017, known as the Tax Cuts and Jobs Act, allows pass-through entities, such as partnerships, limited liability companies, and S corporations, and sole proprietorships and independent contractors to deduct 20% of their qualified business income. However, this deduction starts to phase out for couples earning at least $315,000 or $157,500 for singles.
Compensation paid to employees, such as salary, wages, bonuses, vacation and sick pay, and fringe benefits are deductible by the employer. Employment tax credits reduce the deductible amount, dollar for dollar. However, there are 5 tests to determine whether compensation is deductible. These tests are primarily designed to prevent abuses when compensating either owners of the business or their family members.
Test 1 requires that compensation must be an ordinary and necessary business expense. A necessary business expense is one that is helpful to the business; an ordinary business expense is one that is common for a particular type of business. Ordinary expenses are common because they are necessary business expenses for that type of business.
Test 2 requires that compensation be reasonable, which applies mostly to owner-employees of corporations, not rank-and-file employees. Some factors that the IRS considers in determining whether compensation is reasonable include:
- employee pay policy
- employee pay in regard to the overall net profit of the business
- the duties of the employee and the time required to perform those duties
- local living expenses
- the compensation paid to employees in similar jobs in other businesses
Test 3 requires that a reasonable amount of work must be performed for the amount paid. This test pertains mostly to family members, since there are tax advantages to employing family members, especially children younger than 18. For instance, a business owner could employ her children, deduct the compensation from revenue, saving on both ordinary income tax and employment taxes on her own income while providing her children with income that is free of employment taxes and, within certain limits, free of ordinary income taxes. Without a work requirement, a business owner can simply give money to her children and deduct the amount without having them actually do any work, or even if they were not old enough to perform the work.
Test 4 requires that compensation only be deducted when actually paid by a business owner on a cash basis or when the expense for the compensation is incurred by an accrual basis business, meaning that the work has already been performed.
Test 5 applies to accrual basis businesses in that yearend bonuses, vacation pay or other compensation cannot be deducted unless they are actually paid within 2½ months after the tax year. Compensation to shareholders of C corporations who own more than 50% of the stock or to owners of pass-through entities cannot be deducted until paid.
Other types of deductible compensation include:
- severance pay, which is pay to terminated employees, to help them seek other employment;
- outplacement services for laid-off workers, including career counseling, skills assessment, and resume assistance;
- payments to employees for idle time during which they provide no services;
- back pay ordered by a court or a government agency;
- non-excessive golden parachute payments for certain key employees, which is considered compensation triggered by a change in control of the business;
- if interest on any loans of at least $10,000 to an employee is below the applicable federal rate, then the difference is considered compensation;
- this rule also applies to any loan with a purpose of lowering federal tax liability;
- payments under a salary continuation plan to owner-employees because of disability;
- cash payments or other incentives to promote the purchase of a hybrid vehicle by employees.
Deduction Limits on Other Types of Compensation
Deferred compensation is deductible only when paid, even if the business is on an accrual basis. Employee achievement awards, given for a length-of-service of at least 5 years or for safety achievement, are deductible as compensation, but the maximum deduction is $1600 per employee. There is no dollar limit on a qualified achievement award if given pursuant to a written plan that does not favor highly compensated employees in regards to either eligibility or to benefits; otherwise, it will be regarded as a nonqualified award, subject to a deductibility limit of $400 per employee.
Any compensation paid with property is taxed to the employee on the value of the property at the time of receipt, but the employer can only deduct its basis in the property. So if the employer gives an employee a car worth $25,000 in which the employer had a basis of $18,000, then the employee is taxed on the $25,000, but the employer can only deduct $18,000. However, if there are restrictions on the property (e.g., employee stock), such as being unable to sell it, then no deduction is allowed until the property is substantially vested, meaning without restrictions.
Compensation Deducted as Other Expenses
Some types of compensation must be deducted as other expenses, such as fees paid to an employment agency for recruiting employees. Director's fees, even if they are paid officers or other employees of the corporation, are not treated as compensation, but are deducted as other expenses.