Tests for Deductibility To be deductible, your employees' pay must be an ordinary andnecessary expense and you must pay or incur it in the tax year. Theseand other requirements that apply to all business expenses areexplained under What Can Be Deducted? and When Can anExpense Be Deducted? in chapter 1. In addition, the pay must meet both of the following tests. Test 1. The pay must bereasonable. Test 2. The pay must be for servicesperformed. If these tests are met, the form or method of figuring the paydoes not affect its deductibility. For example, bonuses andcommissions based on sales or earnings and paid under an agreementmade before the services were performed are generally deductible. Employee-shareholder salaries.If a corporation pays an employee who is also a shareholder asalary that is unreasonably high considering the services actuallyperformed by the employee-shareholder, the excessive part of thesalary may be treated as a constructive distribution of earnings tothe employee-shareholder. For more information on corporatedistributions to shareholders, see Publication 542,Corporations. Test 1--Reasonable Determine the reasonableness of pay by the facts. Generally,reasonable pay is the amount that like enterprises ordinarily wouldpay for the services under similar circumstances. You must be able to prove the pay is reasonable. Base this test onthe circumstances that exist when you contract for the services, notthose existing when the reasonableness is questioned. If the pay isexcessive, you can deduct only the part that is reasonable. Factors to consider.To determine if pay is reasonable, consider the following items andany 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 general cost of living in the locality. The ability and achievements of the individual employeeperforming the service. The pay compared with the amount of gross and net income ofthe business, as well as with distributions to shareholders if thebusiness is a corporation. Your policy regarding pay for all of your employees. The history of pay for each employee. Individual salaries.You must base the test of whether a salary is reasonable on eachindividual's salary and the service performed, not on the totalsalaries paid to all officers or all employees. For example, even ifthe total amount you pay to your officers is reasonable, you cannotdeduct an individual officer's entire salary if it is not reasonablebased on the items listed above. Test 2--For Services Performed You must be able to prove the payment was made for servicesactually performed.