You can generally deduct the amount you pay your employees for the services they perform. The pay may be in cash, property, or services. It may include wages, salaries, bonuses, commissions, or other non-cash compensation such as vacation allowances and fringe benefits. For information about deducting employment taxes, see chapter 5.

See chapter 12 for information about getting publications and forms.

To be deductible, your employees' pay must be an ordinary and necessary business expense and you must pay or incur it. These and other requirements that apply to all business expenses are explained in chapter 1.

In addition, the pay must meet both of the following tests.

• Test 1. It must be reasonable.
• Test 2. It must be for services performed.

The form or method of figuring the pay does not affect its deductibility. For example, bonuses and commissions based on sales or earnings, and paid under an agreement made before the services were performed, are both deductible.

You must be able to prove that the pay is reasonable. Whether the pays is reasonable depends on the circumstances that existed when you contracted for the services, not those that exist when reasonableness is questioned. If the pay is excessive, the excess pay is disallowed as a deduction.

Determine the reasonableness of pay by the facts and circumstances. Generally, reasonable pay is the amount that a similar business would pay for the same or similar services.

To determine if pay is reasonable, also consider the following items and any other pertinent facts.

• The duties performed by the employee.
• The volume of business handled.
• The character and amount of responsibility.
• The complexities of your business.
• The amount of time required.
• The cost of living in the locality.
• The ability and achievements of the individual employee performing the service.
• The pay compared with the gross and net income of the business, as well as with distributions to shareholders if the business is a corporation.
• Your policy regarding pay for all your employees.
• The history of pay for each employee.

You must be able to prove the payment was made for services actually performed.

If a corporation pays an employee who is also a shareholder a salary that is unreasonably high considering the services actually performed, the excessive part of the salary may be treated as a constructive dividend to the employee-shareholder. The excessive part of the salary would not be allowed as a salary deduction by the corporation. For more information on corporate distributions to shareholders, see Publication 542, Corporations.