Paid by Your Corporation on a W-2 and a 1099: What the Company Must Prove to Deduct the Extra Pay

If your corporation paid you a W-2 salary and also paid you separate “contractor” or “subcontractor” fees, it can deduct those extra payments only if it can prove they paid for services you actually performed. When fees sit on top of a salary, that means evidence of what separate work they bought and the arrangement behind it; otherwise the salary looks like the pay for your ordinary job. Reporting the money on your personal return does not prove the company’s deduction, and an officer who works in the business is generally its employee for payroll-tax purposes.

That was the problem in Glass Warehouse, LLC v. Commissioner, T.C. Memo. 2026-111, where a closely held C corporation lost a $118,302 deduction, most of it fees paid to its two shareholder-officers on top of their wages. Our case analysis covers the court’s reasoning; this guide covers what to document. It addresses a C corporation’s federal deduction. S corporations, partnerships and state tax raise their own questions.

Show what the extra payment bought

Section 162(a)(1) allows a business to deduct a reasonable allowance for compensation for personal services “actually rendered.” The regulation on compensation asks whether payments are reasonable and “are in fact payments purely for services.” And the recordkeeping rule requires records sufficient to establish each deduction.

For an owner already on payroll, the first question is what the extra money paid for. In Glass Warehouse, the only witness described one owner’s ordinary management work (sales, inventory, staff and customers) and nothing specific about the other’s. The court reasoned that the W-2 wages presumably already paid for that work.

Our suggestion: describe the additional work concretely. Say what was done, when, what it produced, and why it fell outside the salaried role. A project with a defined scope and a deliverable is far easier to prove than general help running the company.

Set the arrangement down before the work

The court accepted that a corporation may pay its officers extra for additional services. What it lacked was evidence that such an arrangement existed: no contracts, invoices, Forms 1099 or payroll records, and an accounting manager who knew of no agreement with either owner.

For contingent pay, the compensation regulation favors a “free bargain” between the company and the individual “made before the services are rendered.” More generally, a written arrangement made in advance is the best evidence of what extra pay was for. In practice, useful records include:

• The agreement: a written scope, rate or fee and term, approved by the company before the work.
• Proof of the work: invoices, time records, project files or other work product.
• The payment trail: bank records tying each payment to an invoice, and ledger entries coded consistently.
• Year-end reporting: the information return the company filed for the payment.
• A witness: someone with first-hand knowledge. In Glass Warehouse, neither owner testified.

Check whether the contractor label fits an officer

Under the employment-tax regulation, “Generally, an officer of a corporation is an employee of the corporation.” The narrow exception covers an officer who performs no or only minor services and neither receives nor is entitled to receive any pay, directly or indirectly. If an employment relationship exists, calling the worker an independent contractor is “immaterial.” The IRS Form 1099-NEC instructions use that form for services performed by someone who is not your employee, and tell payers to report wages paid to employees on Form W-2.

Our reading: if the “extra” work is really more of the officer’s own job, a contractor label is hard to defend, and the payment may raise payroll-tax questions as well as the deduction question. Glass Warehouse rejected an argument that the employment-tax misclassification rule in section 3509 turns an unproved contractor expense into deductible wages. Have the classification reviewed before choosing how to report the next payment.

Your own return does not prove the company’s deduction

Matching reporting does not help the company. Even if you reported the fees and paid employment tax on them, the corporation is a separate taxpayer and must prove its own expense with its own records. That argument failed in Glass Warehouse.

Payments that follow ownership draw a dividend question

The compensation regulation warns that in a corporation with few shareholders, “an ostensible salary paid by a corporation may be a distribution of a dividend on stock,” especially where excessive payments track stockholdings. Under the same regulation, an amount paid as compensation but not in fact for services is not deductible.

In Glass Warehouse the IRS raised this point, but the court decided the case on missing proof instead. Our suggestion: if extra owner payments mirror ownership splits, or bookkeeping entries move “distributions” into an expense account, expect questions and be ready to explain them with records.

If a penalty is proposed, prove what your preparer knew

A disallowed deduction can bring a 20% accuracy-related penalty. Reasonable cause and good faith can defeat it, but under the reasonable-cause regulation, reliance on professional advice counts only if it was reasonable and in good faith, and it fails if the taxpayer did not disclose a fact it knew, or reasonably should have known, was relevant.

In Glass Warehouse, the IRS conceded the penalty for 2019, the year of the owner fees. The court sustained a penalty for 2018, computed from adjustments the parties had settled, finding no reasonable cause: an outside CPA firm signed the return, but no evidence showed what the firm was told or advised. Our suggestion: keep the emails, questions and documents you gave your preparer about owner payments, and any written advice you received.

If the original records are scattered or lost, our guide to rebuilding proof of disputed deductions covers replacement records.