The Internal Revenue Code treats the amount you pay in employee salaries as a normal business expense that is fully deductible. However, the employment relationship must satisfy numerous requirements before you can take a deduction. In limited circumstances, the deduction for compensation you provide may be subject to reductions or disallowed.
The IRS requires that the salary you pay an employee to be reasonable in amount and will disallow any salary deduction that is excessive. The tax laws do not provide a quantitative threshold for what constitutes a reasonable salary; rather, the determination is made in the context of the specific employee and takes into account all facts and circumstances. Factors the IRS will consider in making a determination is the recent salary history of the employee, the complexity of his duties, the necessary time commitment to complete tasks each week, the cost of living in the area where the business is located and the level of management responsibility you provide the employee. If the IRS concludes that a salary is unreasonable, it will only disallow the deduction for the portion that is excessive.
In addition to the salary being reasonable in amount, the compensation you provide to the employee must be solely for services the employee renders. A promise by an employee to perform services in the future does not satisfy this requirement. For example, if you hire an employee who grants the business an exclusive license to manufacture a product that he holds a patent for, the IRS may find that a portion of his compensation is for the purchase of the license and not solely in exchange for services.
When you provide your employees with property or monetary gifts in addition to their salary, the value of the gift is included in their taxable wages and is deductible to you as a business expense. The tax regulations classify certain fringe benefits as non-taxable to the employee but remain partially deductible to the employer. For example, if you provide lunch to your employees at the work location for the benefit of the business, such as to keep them at their desks during lunch breaks, you do not include the value of the meals in their wages. If the meal has a relatively small value, you may deduct 100 percent of its cost; otherwise, you may only deduct 50 percent of the cost.
One of the few exceptions to the rule allowing you to deduct salaries applies to self-employment situations. If you are a sole proprietor, the IRS does not treat the business as a separate taxpayer. You must report all business earnings and deductions on the Schedule C attachment to your personal tax return. You may not reduce the taxable earnings you report by any salary you pay to yourself. This rule remains applicable regardless of the amount of services you provide to the business.