Business Tax Preparation · Business expenses, deductions and credits

Officers and employees' compensation

Compensation is the largest deduction most businesses take and the one most often adjusted on examination. Three separate questions decide it: whether the amount is deductible at all, when it is deductible, and whether what the employee received is taxable to them. The three have different answers and different statutes.

The rule

The deduction. all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on a trade or business, including a reasonable allowance for salaries or other compensation for personal services actually rendered^TY2026 (IRC § 162(a), (a)(1)). the allowance must be reasonable in amount and the services must actually have been rendered — two separate requirements, either of which can defeat the deduction on its own^TY2026 (IRC § 162(a)(1)).

The cap on public company pay. $1,000,000 — a publicly held corporation may not deduct applicable employee remuneration with respect to a covered employee to the extent it exceeds that amount for the taxable year^TY2026 (IRC § 162(m)(1)), and a covered employee is the principal executive officer and principal financial officer at any time during the year, anyone among the 3 highest compensated officers whose pay must be reported to shareholders, and — for taxable years beginning after 31 December 2026 — anyone among the 5 highest compensated employees besides those^TY2026 (IRC § 162(m)(3)).

Timing, where the payee is related. where the payee will not include the amount until paid because of their method of accounting, and payee and payer are related persons at the close of the payer's year, the deduction is deferred to the day the amount is includible in the payee's gross income^TY2026 (IRC § 267(a)(2)), and a personal service corporation within IRC § 441(i)(2) and any employee-owner of it are treated as related persons for the matching rule^TY2026 (IRC § 267(a)(2), closing sentence).

What the employee excludes. a no-additional-cost service, a qualified employee discount, a working condition fringe, a de minimis fringe, a qualified transportation fringe, a qualified moving expense reimbursement, qualified retirement planning services, and a qualified military base realignment and closure fringe^TY2026 (IRC § 132(a)), plus employer-provided accident and health coverage under IRC § 106(a) and $50,000 — the cost of group-term life insurance carried by the employer is included in the employee's gross income only to the extent it exceeds the cost of that much insurance plus anything the employee paid toward it^TY2026 (IRC § 79(a)).

Who is an employee. any officer of a corporation is an employee for employment tax purposes, as is any individual who has the status of an employee under the usual common law rules^TY2026 (IRC § 3121(d)(1), (d)(2)), and beyond them an agent-driver or commission-driver distributing meat, vegetable, fruit or bakery products, beverages other than milk, or laundry or dry-cleaning services; a full-time life insurance salesman; a home worker on materials furnished by the principal and required to be returned; and a full-time traveling or city salesman soliciting orders for one principal^TY2026 (IRC § 3121(d)(3)) — but only where the contract of service must contemplate that substantially all the services are performed personally, and the individual is excluded if they have a substantial investment in facilities used in the work other than transportation facilities, or if the services are a single transaction not part of a continuing relationship^TY2026.

Where the owner is the employee. for purposes of the fringe benefit provisions of subtitle A the S corporation is treated as a partnership and any 2-percent shareholder is treated as a partner of that partnership^TY2026 (IRC § 1372(a)), with more than 2 percent — a person who owns, or is considered to own within the meaning of § 318, on any day during the taxable year more than 2 percent of the outstanding stock or stock possessing more than 2 percent of the total combined voting power^TY2026 (IRC § 1372(b)).

Current figures

How it works in practice

Two tests, not one. the allowance must be reasonable in amount and the services must actually have been rendered — two separate requirements, either of which can defeat the deduction on its own^TY2026 (IRC § 162(a)(1)). The reasonableness question is familiar; the services question is the one that decides family employment cases. A salary paid to a child who does no work fails the second test entirely, and no amount of reasonableness argument reaches it. Conversely a salary that is high but paid for real work is attacked only on reasonableness, where the usual comparators are the duties performed, the employee’s qualifications, what similar businesses pay, and whether the payment tracks profits rather than services.

Where the owner is also the shareholder, look for the disguise. In a C corporation the pressure runs toward calling a distribution “salary,” because salary is deductible and a dividend is not. In an S corporation it runs the other way, because salary carries employment tax and a distribution does not. The statute is the same in both cases — IRC § 162(a)(1) allows only a reasonable allowance for services actually rendered — and the two arguments are mirror images of each other.

The timing trap is IRC § 267(a)(2). where the payee will not include the amount until paid because of their method of accounting, and payee and payer are related persons at the close of the payer's year, the deduction is deferred to the day the amount is includible in the payee's gross income^TY2026. An accrual method corporation that accrues a bonus to a cash method shareholder at the year end and pays it in March does not deduct it in the accrual year; the deduction waits until the shareholder includes it. And a personal service corporation within IRC § 441(i)(2) and any employee-owner of it are treated as related persons for the matching rule^TY2026, which extends the rule to a personal service corporation and its employee-owners even where the ordinary ownership tests of IRC § 267(b) are not met.

Separate the employer’s deduction from the employee’s exclusion. They are different questions with different answers. An employer generally deducts what it pays, whether or not the employee excludes it; the employee excludes only what a provision says they may. That is why a health club membership is deductible by the employer and taxable to the employee, while employer-paid health coverage is deductible by the employer and excluded by the employee under IRC § 106(a).

Learn the exclusions by their statutory names. a no-additional-cost service, a qualified employee discount, a working condition fringe, a de minimis fringe, a qualified transportation fringe, a qualified moving expense reimbursement, qualified retirement planning services, and a qualified military base realignment and closure fringe^TY2026 (IRC § 132(a)). Each of the eight has its own definition and its own conditions, and the two that matter most in practice are the working condition fringe — the value of something the employee could have deducted had they paid for it, which is why business use of a company car is excluded and personal use is not — and the de minimis fringe, which is why occasional subsidised meals are excluded and a gift card is not. IRC § 132 is a list of named categories, not a general reasonableness test.

Group-term life has a figure. $50,000 — the cost of group-term life insurance carried by the employer is included in the employee's gross income only to the extent it exceeds the cost of that much insurance plus anything the employee paid toward it^TY2026 (IRC § 79(a)). Note what the statute actually says: the amount included is the cost of the excess coverage, computed under the IRC § 79 tables, not the excess of the face amount over the threshold.

Statutory employees are a narrow list. an agent-driver or commission-driver distributing meat, vegetable, fruit or bakery products, beverages other than milk, or laundry or dry-cleaning services; a full-time life insurance salesman; a home worker on materials furnished by the principal and required to be returned; and a full-time traveling or city salesman soliciting orders for one principal^TY2026 (IRC § 3121(d)(3)) — four categories, and no others. The two disqualifying conditions matter as much as the categories: the contract of service must contemplate that substantially all the services are performed personally, and the individual is excluded if they have a substantial investment in facilities used in the work other than transportation facilities, or if the services are a single transaction not part of a continuing relationship^TY2026. A statutory employee receives a Form W-2 with a box ticked, pays no self-employment tax on the earnings, and deducts business expenses on Schedule C rather than as an employee.

And where the employee owns the business, the fringe benefit rules change. for purposes of the fringe benefit provisions of subtitle A the S corporation is treated as a partnership and any 2-percent shareholder is treated as a partner of that partnership^TY2026 (IRC § 1372(a)), where more than 2 percent — a person who owns, or is considered to own within the meaning of § 318, on any day during the taxable year more than 2 percent of the outstanding stock or stock possessing more than 2 percent of the total combined voting power^TY2026 (IRC § 1372(b)). A partner is never an employee of the partnership for these purposes; a more-than-2-percent S corporation shareholder is treated as though they were a partner. The corporation still deducts the cost, but as compensation rather than as an excluded benefit.

How this has changed

IRC § 162(m) expands after 2026, and 2026 is the last year of the current definition. the principal executive officer and principal financial officer at any time during the year, anyone among the 3 highest compensated officers whose pay must be reported to shareholders, and — for taxable years beginning after 31 December 2026 — anyone among the 5 highest compensated employees besides those^TY2026 (IRC § 162(m)(3)). Subparagraph (C) reaches “the 5 highest compensated employees for the taxable year” other than the officers already covered, and applies “in the case of taxable years beginning after December 31, 2026.” So a calendar-year public company has one more year in which only the principal executive officer, the principal financial officer and the three highest paid officers are covered. From 2027 the group widens to include the five highest paid employees, which reaches people who are not officers at all — and the covered-employee status, once acquired, does not lapse.

The 2017 Act removed the performance-based escape. Before Pub. L. 115-97 § 13601, commission and qualified performance-based compensation were excluded from applicable employee remuneration, which meant the cap rarely bit. That exclusion is gone, so the cap now applies to the whole of a covered employee’s remuneration. Material describing a performance-based exception is describing law that ended for taxable years beginning after 2017.

The fringe benefit list lost a member in substance. IRC § 132(a)(6) still names a qualified moving expense reimbursement, but IRC § 132(g)(2) suspends the exclusion for taxable years beginning after 31 December 2017 except for members of the Armed Forces on active duty moving under military order. The paragraph is still in the list; for almost every employer it is inoperative.

Exam focus

Expect a family employment question, and answer it on the second limb of IRC § 162(a)(1) before reaching reasonableness. Services actually rendered is the test that disposes of the clear cases.

Expect a fringe benefit sorting question. Work from the eight named categories of IRC § 132(a) plus the separate provisions — IRC § 106 for health coverage and IRC § 79 for group-term life — rather than from intuition about what feels like a perk.

Expect IRC § 267(a)(2) somewhere, usually disguised as an accrual question. The signal is an accrual method payer, a cash method payee, and a relationship between them.

Finally, keep the two levels apart throughout. Almost every wrong answer in this topic is a true statement about the employer offered as an answer about the employee, or the reverse.

Check yourself

1. A corporation accrues a $90,000 bonus on 31 December to an employee who owns 70 percent of its stock and pays it on 1 April. When is it deductible?

Answer: In the year of payment. where the payee will not include the amount until paid because of their method of accounting, and payee and payer are related persons at the close of the payer's year, the deduction is deferred to the day the amount is includible in the payee's gross income^TY2026 (IRC § 267(a)(2)) — the payee is a cash method taxpayer who will not include the amount until paid, and the two are related persons at the close of the payer’s year, so the deduction moves to the day the amount is includible.

2. An employer provides $200,000 of group-term life insurance to each employee. What does an employee include?

Answer: The IRC § 79 table cost of the coverage above the threshold, not $150,000. $50,000 — the cost of group-term life insurance carried by the employer is included in the employee's gross income only to the extent it exceeds the cost of that much insurance plus anything the employee paid toward it^TY2026 (IRC § 79(a)) — the inclusion is the cost of the excess insurance, reduced by anything the employee paid toward it.

3. A company pays for its employees’ commuting parking, occasional office snacks, and annual theatre tickets. Which are excluded?

Answer: The parking is a qualified transportation fringe under IRC § 132(a)(5) and the snacks are a de minimis fringe under IRC § 132(a)(4). The theatre tickets fall into none of the eight categories in a no-additional-cost service, a qualified employee discount, a working condition fringe, a de minimis fringe, a qualified transportation fringe, a qualified moving expense reimbursement, qualified retirement planning services, and a qualified military base realignment and closure fringe^TY2026 and are taxable compensation, though the company deducts all three.

4. A full-time life insurance salesman works for one company under a contract requiring him to perform the services personally, and has no substantial investment in facilities. How is he treated?

Answer: As a statutory employee. an agent-driver or commission-driver distributing meat, vegetable, fruit or bakery products, beverages other than milk, or laundry or dry-cleaning services; a full-time life insurance salesman; a home worker on materials furnished by the principal and required to be returned; and a full-time traveling or city salesman soliciting orders for one principal^TY2026 (IRC § 3121(d)(3)(B)) names the category and the contract of service must contemplate that substantially all the services are performed personally, and the individual is excluded if they have a substantial investment in facilities used in the work other than transportation facilities, or if the services are a single transaction not part of a continuing relationship^TY2026 are both satisfied. He receives a Form W-2, pays no self-employment tax on those earnings, and deducts his business expenses on Schedule C.

5. Why does a payment to a family member who performs no work fail even if the amount is modest?

Answer: Because the allowance must be reasonable in amount and the services must actually have been rendered — two separate requirements, either of which can defeat the deduction on its own^TY2026 (IRC § 162(a)(1)) requires both that the allowance be reasonable and that the services have actually been rendered. A modest amount satisfies the first and cannot cure the absence of the second.