Can You Write Off Labor Costs on Business Taxes?

Businesses can deduct labor costs when calculating their taxable income, which reduces the amount of income subject to taxation. By subtracting these expenses from gross revenues, a company lowers its net profit for tax purposes. The principles governing these deductions are outlined by the Internal Revenue Service (IRS) and apply to various business structures.

Defining Deductible Labor Costs

For a labor cost to be deductible, the IRS requires it to be both an “ordinary and necessary” expense. An ordinary expense is one that is common and accepted in your trade or industry. A necessary expense is one that is helpful and appropriate for your business, and it must be directly related to the business’s operations.

The most direct form of deductible labor cost is the salaries and wages paid to employees, including regular pay, overtime, commissions, and bonuses. Any direct payment to an employee for their work can be deducted, provided it is a reasonable amount for the services performed. Reasonableness is based on what similar businesses would pay for comparable services.

Beyond direct pay, other forms of employee compensation are also deductible. Contributions a business makes to employee benefit programs, such as health insurance plans, accident plans, and certain life insurance programs, can be written off. Employer contributions to qualified retirement plans, like 401(k)s or SIMPLE IRAs, are also deductible expenses.

The employer’s share of payroll taxes is another deductible labor cost. These taxes include the employer’s portion of Social Security and Medicare taxes, known as FICA taxes. Additionally, businesses must pay federal and state unemployment taxes, which are fully deductible.

Differentiating Worker Classifications

Correctly classifying workers as either employees or independent contractors is important for federal tax purposes, as it affects tax withholding and deductions. The IRS evaluates the degree of control and independence in the working relationship using three main categories to clarify a worker’s status.

Behavioral Control

Behavioral control examines whether the business has the right to direct how the worker does their job. This involves evaluating who provides instructions about when, where, and how to work. If the business provides detailed training and specific procedures the worker must follow, this suggests an employer-employee relationship. For example, requiring tasks to be performed in a specific sequence during set hours points toward employee status.

Financial Control

Financial control looks at the business aspects of the worker’s job, including how the worker is paid and whether expenses are reimbursed. It also considers who provides the tools and supplies. An independent contractor is more likely to have a significant investment in their own equipment and is often paid a flat fee for a project. An employee is often paid on a recurring schedule, has business expenses reimbursed, and uses tools provided by the company.

Relationship of the Parties

This category considers how the worker and business perceive their interaction, including any written contracts, though contracts are not the sole determinant. The presence of employee-type benefits, such as insurance or paid vacation, indicates an employer-employee relationship. The permanency of the relationship is another factor. A relationship expected to continue indefinitely suggests employment, while one focused on a specific project points toward independent contractor status.

Required Documentation and Information

For individuals classified as employees, a business must collect specific forms to comply with federal requirements. The first is Form W-4, Employee’s Withholding Certificate, which is used to determine the correct amount of federal income tax to withhold from an employee’s pay. The second is Form I-9, Employment Eligibility Verification, which verifies a person’s identity and authorization to work in the U.S.

Businesses must also maintain payroll records for each employee. These records should include the amounts and dates of all wage payments, commissions, bonuses, and any tips reported. It is also necessary to track the value of any benefits provided, such as health insurance contributions. This information is aggregated annually onto Form W-2, Wage and Tax Statement, which reports the employee’s total annual wages and taxes withheld.

For independent contractors, a business must obtain a completed Form W-9, Request for Taxpayer Identification Number and Certification, from each contractor before payment. This form provides the contractor’s legal name, address, and Taxpayer Identification Number (TIN).

The information from Form W-9 is used to prepare Form 1099-NEC, Nonemployee Compensation. This form is required if a business pays a contractor $600 or more for services during the calendar year. The 1099-NEC reports the total amount of compensation paid to the contractor.

Reporting Labor Costs on Tax Returns

Businesses must file the informational returns with the correct government agencies. Copy A of all Form W-2s must be sent to the Social Security Administration (SSA), while Copy A of Form 1099-NEC must be filed with the IRS. The deadline for submitting these forms and providing copies to workers is January 31 of the year following payment.

After filing, the business can claim these deductions on its annual income tax return. The location for reporting these costs depends on the business’s structure. A sole proprietor reports employee wages on the “Wages” line of Schedule C (Form 1040) and payments to independent contractors on the “Contract Labor” line.

Other business entities use their respective tax forms. C corporations report salaries and wages on Form 1120, U.S. Corporation Income Tax Return. S corporations use Form 1120-S to report officer compensation and employee wages separately. Partnerships report these costs on Form 1065, U.S. Return of Partnership Income. The total amounts reported on the tax return should align with the totals from the W-2 and 1099 forms filed.