Building Your Business Operations & Success Accounting When Are Salaries and Wages Tax-Deductible Expenses? You don’t pay taxes on salary and wages you pay By Rosemary Carlson Updated on September 19, 2022 Fact checked by Mrinalini Krishna In This Article View All In This Article Cash vs. Accrual Method for Tax-Deductible Expenses Salaries and Wages Must Be Deemed Reasonable Is Your Compensation Tax-Deductible? What Other Compensations Are Tax-Deductible? Frequently Asked Questions (FAQs) Photo: Tim Kitchen / Getty Images Salaries, wages, commissions, and bonuses that you pay to your employees are often tax-deductible to you, subject to numerous rules imposed by the Internal Revenue Service (IRS). The payments must be “ordinary and necessary,” and they must be reasonable in amount. You must pay for services that were actually provided, and they must be paid for or incurred in the current tax year. 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. Key Takeaways Salaries and wages are only deductible in the tax year you make them, but this can depend on your method of accounting.The payments must be considered reasonable and necessary in the course of your business.These and other rules also apply to bonuses, awards, vacation pay, and sick leave.Check with a tax professional if you’re unsure of the status of any payments you’ve made to your workers. 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. Note It's not unusual for the taxpayer and the IRS to have differing views of what's reasonable compensation. It can help to determine if the compensation you're paying is competitive across the industry you operate in. 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. Note Consult with accounting and/or tax professionals for information that’s specific to your business. 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. Frequently Asked Questions (FAQs) Is stock-based compensation tax-deductible? Yes, but not all stock-based compensation. For example, certain qualified stock options may not be tax-deductible for you as the employer. Additionally, some stock-based compensation may not be deductible until the employee is vested or the option is exercised. Work with an accountant and/or financial advisor if you plan to offer employees stock-based compensation. Why is employee compensation tax-deductible? Employee compensation is tax-deductible for you as the employer because you’re paying for services that are necessary for your business. The IRS calls this type of expense “ordinary and necessary” for your business because it helps your business. Updated by Beverly Bird Was this page helpful? Thanks for your feedback! Tell us why! Other Submit Sources The Balance uses only high-quality sources, including peer-reviewed studies, to support the facts within our articles. Read our editorial process to learn more about how we fact-check and keep our content accurate, reliable, and trustworthy. Internal Revenue Service. “Publication 535 (2021), Business Expenses - What Can I Deduct?” Internal Revenue Service. “Publication 535 (2021), Business Expenses - Tests for Deducting Pay.” Internal Revenue Service. “Publication 538 (01/2022), Accounting Periods and Methods.” Internal Revenue Service. “Exempt Organization Annual Reporting Requirements: Meaning of "Reasonable" Compensation.” Internal Revenue Service. “Sole Proprietorships.” Cornell Law School Legal Information Institute. “Pass-Through Taxation.” Internal Revenue Service. “Publication 535 (2021), Business Expenses - Kinds of Pay” Internal Revenue Service. “Topic No. 427 Stock Options.”