A sole shareholder pays herself $40,000 and her 14-year-old son $60,000 for filing papers, then rents her own garage to the corporation for $90,000. Three deductions, three different limits.
Before a business can deduct what it pays its officers and employees, that pay has to pass a test. IRC §162(a)(1) allows a deduction for a reasonable allowance for salaries or other compensation for personal services actually rendered. Four conditions decide whether any payment to officers and employees is deductible.
The four-part test:
- Ordinary and necessary: the payment is common in the trade or business and helpful to it. "Necessary" means appropriate, not indispensable.
- Reasonable in amount: compare the total pay with what a similar business would pay for similar services.
- Services actually rendered: the person must really do the work, so a paper salary paid to someone who did no work gets no deduction.
- Paid or incurred: the deduction must land in the right year. A cash-method payer deducts compensation when paid.
Common mistakes
- Treating a gift card as de minimis. Cash and cash equivalents are always taxable wages, no matter how small. A $25 gift card is fully includible in wages.
- Deducting qualified transportation fringe benefits. The $325 monthly parking benefit stays tax-free to the employee, but §274(a)(4) denies the employer the deduction entirely.
- Applying the under-18 FICA exemption to a corporation. A child working for a parent's S corporation pays full FICA. The exemption requires a sole proprietorship or a partnership where both partners are the child's parents.
Bottom line
- Compensation must be ordinary, necessary, reasonable, and for services actually rendered; C corporations get squeezed for paying owners too much, S corporations for paying too little.
- Section 162(m) caps public-company deductions at $1,000,000 per covered employee; §267(a)(2) defers accrued salary to a more-than-50-percent shareholder until included in income; unrelated-party bonuses need payment within 2.5 months.
- Cash and gift cards are never de minimis; educational assistance excludes $5,250; group-term life excludes the first $50,000 of coverage; dependent care excludes $5,000.
- Qualified transportation is excludable to the employee at $325 per month but not deductible by the employer.
Exam shortcut
Read the entity form before anything else. "Sole proprietor" plus a child's age is a payroll-tax question; "corporation" in the same stem kills every family exemption and the answer choice preserving one is the distractor. When a stem names a percentage owner and a fringe benefit, check for "more than 2 percent" and "S corporation" together.
The full lesson (about 3,166 words, 21 min read) adds 2 worked examples, all 6 common mistakes, a self-check, free in the app.
Learning objectives
- 2
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