[Code of Federal Regulations]
[Title 26, Volume 2]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.162-7]

[Page 780-781]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.162-7  Compensation for personal services.

    (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.

[[Page 781]]

    (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.