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The IRS will generally accept your charac- terization if it is supported by facts and circum- stances. If you are carrying on two or more dif- ferent activities, keep the deductions and income from each one separate. Figure separately whether each is a not-for-profit activity. Then figure the limit on de- ductions and losses separately for each activity that is not for profit. 2. Employees' Pay What’s New Compensation in excess of $1 million. P.L. 115-97, Tax Cuts and Jobs Act, made signifi- cant changes to section 162(m) which disallows the deduction of excessive employee compen- sation by any publicly held corporation. See Compensation in excess of $1 million, later. Employee achievement awards. P.L. 115-97 defines items that aren't tangible personal prop- erty for purposes of employee achievement awards. Tangible personal property doesn't in- clude cash, gift cards, and other nontangible personal property. See Achievement awards, later. Certain expense deductions are now limi- ted. P.L. 115-97 limits the deduction by em- ployers of expenses for certain fringe benefits and entertainment expenses. For more informa- tion, see the Caution under Meals and lodging, later. Also see Food and beverage expense in- curred together with entertainment expenses. and Transportation (commuting) benefits, later. At the time this publication was printed, the empowerment zone employment credit and the Indian employment credit expired at the end of 2017. To find out if legislation was enacted to extend these credits and make them available for 2018, go to IRS.gov/FormsUpdates. Introduction 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, commis- sions, or other non-cash compensation such as vacation allowances and fringe benefits. For in- formation about deducting employment taxes, see chapter 5. You may be able to claim employment credits, such as the credits listed be- low, if you meet certain requirements. You must reduce your deduction for employee wages by the amount of employment credits that you claim. For more information about TIP CAUTION ! TIP these credits, see the form on which the credit is claimed; you can find a list of these forms in Form (and Instructions) under Useful Items, later. • Work opportunity credit. • Credit for employer differential wage pay- ments. • Employer credit for paid family and medi- cal leave. Topics This chapter discusses: • Tests for deducting pay • Kinds of pay Useful Items You may want to see: Publication 15 Employer's Tax Guide 15-A Employer's Supplemental Tax Guide 15-B Employer's Tax Guide to Fringe Benefits Form (and Instructions) 1099-MISC Miscellaneous Income 5884 Work Opportunity Credit 8932 Credit for Employer Differential Wage Payments 8994 Employer Credit for Paid Family and Medical Leave W-2 Wage and Tax Statement See chapter 13 for information about getting publications and forms. Tests for Deducting Pay 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 expen- ses 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 doesn't 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. Test 1—Reasonableness You must be able to prove that the pay is rea- sonable. Whether the pay is reasonable de- pends 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. Factors to consider. Determine the reasona- bleness of pay by the facts and circumstances. 15 15-A 15-B 1099-MISC 5884 8932 8994 W-2 Generally, reasonable pay is the amount that a similar business would pay for the same or simi- lar services. To determine if pay is reasonable, also con- sider the following items and any other pertinent facts. • The duties performed by the employee. • The volume of business handled. • The character and amount of responsibil- ity. • The complexities of your business. • The amount of time required. • The cost of living in the locality. • The ability and achievements of the indi- vidual employee performing the service. • The pay compared with the gross and net income of the business, as well as with dis- tributions to shareholders if the business is a corporation. • Your policy regarding pay for all your em- ployees. • The history of pay for each employee. Compensation in excess of $1 million. Pub- licly held corporations can't deduct compensa- tion to a “covered employee” to the extent that the compensation exceeds $1 million. For more information, including the definition of a “cov- ered employee,” see the Instructions for Form 1125-E. Also see Notice 2018-68, 2018-36 I.R.B. 418, available at IRS.gov/irb/ 2018-36_IRB#NOT-2018-68. Test 2—For Services Performed You must be able to prove the payment was made for services actually performed. Employee-shareholder salaries. If a corpo- ration pays an employee who is also a share- holder a salary that is unreasonably high con- sidering the services actually performed, the excessive part of the salary may be treated as a constructive dividend to the employee-share- holder. The excessive part of the salary wouldn't be allowed as a salary deduction by the corporation. For more information on corpo- rate distributions to shareholders, see Pub. 542. Kinds of Pay Some of the ways you may provide pay to your employees in addition to regular wages or salar- ies are discussed next. For specialized and de- tailed information on employees' pay and the employment tax treatment of employees' pay, see Pubs. 15, 15-A, and 15-B. Awards You can generally deduct amounts you pay to your employees as awards, whether paid in cash or property. If you give property to an em- ployee as an employee achievement award, your deduction may be limited. Achievement awards. An achievement award is an item of tangible personal property that meets all the following requirements. • It is given to an employee for length of service or safety achievement. Page 8 Chapter 2 Employees' Pay