26 C.F.R. § 1.162-7

Compensation for personal services

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(a) There may be included among the ordinary and necessary expenses paid or incurred in carrying on any trade or business a reasonable allowance for salaries or other compensation for personal services actually rendered. The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.

(b) The test set forth in paragraph (a) of this section and its practical application may be further stated and illustrated as follows:

(1) Any amount paid in the form of compensation, but not in fact as the purchase price of services, is not deductible. An ostensible salary paid by a corporation may be a distribution of a dividend on stock. This is likely to occur in the case of a corporation having few shareholders, practically all of whom draw salaries. If in such a case the salaries are in excess of those ordinarily paid for similar services and the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, it would seem likely that the salaries are not paid wholly for services rendered, but that the excessive payments are a distribution of earnings upon the stock. An ostensible salary may be in part payment for property. This may occur, for example, where a partnership sells out to a corporation, the former partners agreeing to continue in the service of the corporation. In such a case it may be found that the salaries of the former partners are not merely for services, but in part constitute payment for the transfer of their business.

(2) The form or method of fixing compensation is not decisive as to deductibility. While any form of contingent compensation invites scrutiny as a possible distribution of earnings of the enterprise, it does not follow that payments on a contingent basis are to be treated fundamentally on any basis different from that applying to compensation at a flat rate. Generally speaking, if contingent compensation is paid pursuant to a free bargain between the employer and the individual made before the services are rendered, not influenced by any consideration on the part of the employer other than that of securing on fair and advantageous terms the services of the individual, it should be allowed as a deduction even though in the actual working out of the contract it may prove to be greater than the amount which would ordinarily be paid.

(3) In any event the allowance for the compensation paid may not exceed what is reasonable under all the circumstances. It is, in general, just to assume that reasonable and true compensation is only such amount as would ordinarily be paid for like services by like enterprises under like circumstances. The circumstances to be taken into consideration are those existing at the date when the contract for services was made, not those existing at the date when the contract is questioned.

(4) For disallowance of deduction in the case of certain transfers of stock pursuant to employees stock options, see section 421 and the regulations thereunder.

Notes of Decisions

Cited in 245 cases (3 in the last 5 years), 1962–2023 · leading case: Achiro v. Comm'r, 77 T.C. 881 (Tax Ct. 1981).

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Achiro v. Comm'r, 77 T.C. 881 (Tax Ct. 1981). · cites it 4× “Respondent has conceded that if the payments are disallowed as management fees, they should be allowed almost in their entirety as employee salary deductions.”

North Cent. Life Ins. Co. v. Comm'r, 92 T.C. 254 (Tax Ct. 1989). · cites it 12× “162-7(a), Income Tax Regs. To be deductible, compensation may be "contingent" but it cannot be a "distribution of earnings of the enterprise.”

Alondra Indus. v. Comm'r, 1996 T.C. Memo. 32 (Tax Ct. 1996). · cites it 16× “To be deductible *68 under section 162(a)(1), compensation must be both: (1) Reasonable and (2) paid "purely for services" rendered to the business. Sec.”

Wycoff v. Comm'r, 2017 T.C. Memo. 203 (Tax Ct. 2017). · cites it 6× “Section 162(a)(1) allows a taxpayer to deduct "a reasonable allowance for salaries or other compensation for personal services actually rendered" as an ordinary and necessary business expense.”

Laure v. Comm'r, 70 T.C. 1087 (Tax Ct. 1978). · cites it 6× “" The regulations go on to warn that an "ostensible salary," where excessive in relation to that ordinarily paid for similar services and where the excessive payments correspond or bear a close relationship to the stockholdings of the officers or employees, is likely to be in…”

Kennedy v. Comm'r, 72 T.C. 793 (Tax Ct. 1979). · cites it 4× “Reasonable Compensation The deductibility of the compensation paid James depends upon the meaning of section 162(a)(1) , which allows a deduction for compensation which was actually intended to be paid for the services actually rendered and which was reasonable for those…”

Rotolo v. Comm'r, 88 T.C. 1500 (Tax Ct. 1987). · cites it 4× “Among the facts and circumstances to be considered by the Court are: the employee's qualifications; the nature, extent and scope of the employee's work; the size and complexities of the business; a comparison of salaries paid with the gross income and the net income; the…”

Peck v. Comm'r, 90 T.C. 162 (Tax Ct. 1988). · cites it 2× “If any guidance is to be drawn from the compensation area, the regulations provide an apt analogy.”

James D. Kennedy, Jr. & Dorothy H. Kennedy, & Cherokee Warehouses, Inc. v. Comm'r of Internal Revenue, 671 F.2d 167 (6th Cir. 1982). · cites it 3× “Such an agreement was authorized by the Code of Federal Regulations, 26 C.F.R. § 1.162-7 (b)(2)(3). The last sentence in (3) expressly states the circumstances to be taken into consideration in determining the reasonableness of the compensation.”

Acme Constr. Co. v. Comm'r, 69 T.C.M. 1596 (Tax Ct. 1995). · cites it 6× “We must consider the facts of each case in deciding whether a taxpayer meets the requirements for deducting compensation paid under section 162(a)(1) .”

Home Interiors & Gifts, Inc. v. Comm'r, 73 T.C. 1142 (Tax Ct. 1980). · cites it 2× “Horner, it is also significant that all key employees of Home Interiors were compensated on the basis of commissions and that the use of such method of compensation was a longstanding practice of the company.”

Suder v. Comm'r, 2014 T.C. Memo. 201 (Tax Ct. 2014). · cites it 4× “"The test of deductibility in the case of compensation payments is whether they are reasonable and are in fact payments purely for services.”

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