I recently saw an article about a Chick-fil-A store about to undergo a 5-month renovation. The franchisee decided to pay all of his employees their normal wages during the renovation (some even got a raise). This got me thinking about whether the franchisee could deduct those wages.
§162 allows a deduction for “a reasonable allowance for salaries or other compensation for personal services actually rendered” (italics added).
§1.162-7(a) goes on “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” (italics added).
A strict interpretation of this language says that since the employees aren’t rendering services, the franchisee can’t deduct the wages. Thankfully, and not surprisingly, this issue has come up before.
One such time, in Ware Knitters, Inc. v. U.S., a taxpayer was denied a deduction for wages paid to an officer-employee. From 1943 – 1945 this officer-employee worked full-time for a government contractor and was also paid his normal salary by Ware Knitters, Inc. The IRS disallowed the wage deduction based on the language included in §162a “for personal services actually rendered.” The U.S. Court of Claims, where the case was heard, sided with the taxpayer. They provided this explanation –
“In many instances, when a person enters upon his employment he does so in the expectation that an amount shall be paid to him currently for his services, and, also, an amount to be paid later as a pension. Since the pension is for services actually rendered, it has been held that such sums are deductible.
Likewise, if an employee has a long period of illness, during which the company continues to pay his salary, such payments are deductible, because they are paid partly in consideration of past services, as an inducement for him to return, and for services to be rendered when the employee does return to work. His salary is paid, in part, at least, because the company thinks that it is to its profit to pay it in order to secure the employee’s services in the future, and on account of those services.”
In four other casesb though, the IRS has successfully disallowed a deduction for wages paid to former employees who became ill. The reasoning in those cases was that they payments were made for personal reasons rather than to secure future services.
The takeaway here is that payments made to secure future services are deductible even if paid while the employee is not currently working. Payments made for personal reasons to a non-working employee are not deductible.
Footnotes
a At the time of the case, the relevant section was 23(a)(1)(A). It was later changed to §162.
b Bussabarger v. Commissioner 52 T.C. 819 (1969), Snyder & Berman, Inc., 41 B.T.A. 1180, affd. 116 F.2d 165 (C.A. 4, 1940), Desmond’s, Incorporated, 15 B.T.A. 738 (1929), Dreikorn’s Bakery Inc. v. Commissioner 7 T.C.M. 276 (1948)