Understanding the Tax Ramifications of Business Owner Compensation

Businesses that claim tax deductions for wages and salaries — as well as commissions, bonuses, and other compensation to employees — are well within IRS tax laws. However, it’s important to note that if you have a business where you pay the owners and you plan to deduct that on your taxes, it could open you up to more scrutiny from the IRS.

What types of compensation are deductible for businesses can be confusing. Here are some guidelines.

IRS Requirements for Compensation

In order to deduct compensation on taxes, you must ensure that it is:

  • A reasonable amount
  • Ordinary and necessary for the business
  • Payment for actual services provided to the company
  • Incurred or paid in the year you claim the deduction (the one you choose depends on whether you use a cash or accrual accounting method)
  • Deducted at its fair market value, if it’s a form of compensation other than cash, i.e., fringe benefits

Testing Your Own Compensation

Generally, the IRS increases scrutiny of tax deductions for compensation if the person receiving the high compensation has control over the business or a personal relationship with the owners. For many small businesses, those who receive the highest compensation fall into both these categories. If you’re not sure whether your compensation meets these requirements, below are some additional guidelines.

Compensation is generally considered reasonable if someone in a similar position at a similar company would be paid a similar amount. If you have individuals who are highly compensated in your business, make sure:

  • Their duties are essential in keeping the business running successfully.
  • Their hours worked each week are comparable to someone in a similar position at another company with a comparable salary.
  • The person is generally qualified for the position.
  • The pay rate is within the range of salaries for the same position in your industry and geographic area.

If the IRS is reviewing wages or salaries you deducted, they may also ask about how the person is related to the company or owners, and whether they control the company or could disguise corporate distributions as tax-deductible compensation.

Finally, it’s helpful to have a written document that specifies how much will be paid to whom, when and for what. If you pay out a large bonus at the end of the year and do not have a written document from the beginning of the year specifying the amount and reason for the bonus, the IRS may view that as a violation.

Get Help Evaluating Your Risks

What is tax deductible and what is not can be confusing even for seasoned business owners. If you are worried about whether you might fall under increased scrutiny, talk to the tax advisors at Cantley Dietrich to learn more. We can help you identify actions that could raise red flags with IRS auditors, so you stay in compliance with tax laws.