Owners As Employees and Contractors

Many owners of small corporations wear a lot of hats. They run sales. They buy inventory. They manage the staff and keep the customers happy. Most of them also draw a salary through payroll like everyone else on the team.

Then the year winds down. Business was good, and the owners want to take more money out. Someone suggests paying the extra amount as “subcontractor fees” instead of running it through payroll. The owners will report the money on their personal returns anyway. The tax gets paid either way. What could go wrong?

The answer is double taxation, possibly. The question is whether a corporation can deduct payments to its own owners as contractor expenses when those same owners are already on the payroll as employees. And if the owners report the money and pay tax on it, does that prove the corporation gets the tax deduction?

The U.S. Tax Court recently addressed this in Glass Warehouse, LLC v. Commissioner, T.C. Memo. 2026-111. The case provides an opportunity to consider what it takes for a business to deduct payments to owners who are said to be both employees and contractors at the same time.

Facts & Procedural History

The taxpayer is a company that sells glass shower doors and enclosures. It makes sales through large online retailers.

It was organized as an LLC, but it was taxed as a C corporation.

It had about $4.1 million in gross receipts and roughly ten employees. A married couple owned and ran it. The husband owned 80% and the wife owned 20%. Both worked for the company full time and handled every part of the day-to-day operations. An accounting manager ran payroll and the books in QuickBooks. An outside CPA firm prepared the returns.

In 2019, the company issued Forms W-2 to the two owners that reported $167,000 in wages. It also deducted $174,000 in “subcontractor fees.” About $110,000 of the fees went to the owners themselves—about $99,000 to the husband and $11,000 to the wife.

The company did not issue the husband or the wife a Form 1099. There were other issues on the tax return. For example, the officer compensation schedule on the tax return reported less than the W-2 wage amounts paid to them.

The owners did report the $110,000 as wages on their joint personal Form 1040 tax return. They listed it as “other income” on the 1040. So the money was taxed to the owners. The IRS did not question the income. The question from the IRS side was was whether the company could also deduct the contractor payment as an expense.

The IRS audited the company’s tax returns. In 2022, it issued a notice of deficiency that disallowed about $118,000 of the subcontractor deduction for lack of substantiation and it proposed accuracy-related penalties. The company petitioned the U.S. Tax Court to contest the determination. Most of the other issues settled before trial. The subcontractor deduction did not.

What Can a Corporation Deduct as Compensation?

Section 162(a) allows a deduction for “all the ordinary and necessary expenses paid or incurred during the taxable year in carrying on any trade or business.” This includes “a reasonable allowance for salaries or other compensation for personal services actually rendered.” This is the provision that lets a business deduct wages to employees and fees to outside contractors alike.

The label on the payment does not matter much. Wages, bonuses, consulting fees, and contract labor can all be deductible. What matters is that the payment is compensation for services that were actually performed.

The Ninth Circuit, where this case would be appealed, applies a two-part test to compensation deductions. First, the amount has to be reasonable. Second, the business has to make the payment with the intent to compensate for services rendered. Other circuits use similar tests.

The reasonableness prong was not at issue here. The IRS conceded it. The IRS disallowed the deduction only because the company could not substantiate it. That narrowed the case to a simple question. Could the company prove that the owners performed contractor services separate from the work they were already paid wages to do?

Why Do Payments to Owners Draw Extra Scrutiny?

A corporation can deduct compensation. It cannot deduct dividends. This difference is why IRS agents often look closely at any payment a closely held corporation makes to its owners–the IRS looks to impose double tax.

If the payment is really a return on the owner’s investment rather than pay for work, it is a disguised dividend. The deduction goes away and the corporation pays tax on that income by not being able to deduct it as an expense at the entity level.

The IRS raised this theory at trial. It pointed to bookkeeping entries that described “reclassing” the husband’s shareholder distributions as subcontractor payments. The tax court also noted several facts that did not help the company. It had never declared a dividend. It had no bonus plan. The payments closely tracked the owners’ ownership percentages. No other employee received payments outside of their W-2 wages. And 2019 was the only year the owners received both wages and subcontractor fees—the accounting manager could not explain why.

Even so, the tax court declined to decide whether the payments were disguised dividends. It did not need to. The company lost on the more basic issue of proof.

Can an Owner Be Both an Employee and a Contractor?

Yes, in theory. The tax court was clear that a corporation is free to structure its compensation arrangements however it wants. It acknowledged that every business and every executive pay package is different.

A company could pay an owner a salary for running the business and separately pay that same owner a fee for distinct work outside the job, such as a construction project or a specialized consulting engagement.

The key word is distinct. The extra payment has to be for extra services that were actually rendered. That is where the company’s case fell apart.

The company’s only witness was its accounting manager. She described what the owners did. The husband managed “every aspect of the company, customers, inventory buying, all of it.” She offered nothing specific about the wife’s services. She testified that she did not see either owner involved in the business beyond their day-to-day operations work. Neither of them did any groundskeeping or maintenance, for example. In other words, the “subcontractor” work could seem like it was the same work the W-2 wages already covered.

There was nothing else put into the court record. The accounting manager did not know of any subcontractor agreement between the company and either owner. There were no contracts, no invoices, and no Forms 1099. She also testified that when she issued Forms 1099 to other workers, she knew what contract work they had done. She had no such knowledge about the owners. And the owners themselves did not testify. The tax court concluded that the company presented no evidence of the nature, terms, amount, or provider of any subcontractor services.

Thus, the company did not lose this deduction because owners cannot be contractors. It lost the deduction because nothing in the court record showed what the contractor work was. An information return like a Form 1099 would not have proven the deduction by itself. But the absence of one, along with the absence of any agreement or invoice, made it hard to argue that anyone treated this as a real contractor relationship at the time.

Does It Help That the Owners Paid Tax on the Money?

The company’s main argument was a fairness argument. The owners reported the $110,000 on their personal return and paid employment taxes on it. If the government taxed the owners on the payments as contractor income, why should the company not be able to deduct them as contractor expenses?

The tax court rejected this. A corporation is a separate taxpayer from its shareholders. That is a long-standing rule from the Supreme Court, and it cuts both ways. Business owners who choose to operate as a corporation get the benefits of that structure. They also have to accept the tax disadvantages that come with it. How a shareholder reports an item on a personal return has no bearing on how the corporation reports the same item. Each tax return has to stand on its own.

The practical result is harsh. The owners paid income and employment taxes on the money. The company lost its deduction and paid corporate tax on the same money. That is double taxation, and it is exactly what the C corporation structure produces when a payment cannot be shown to be compensation.

Is This Just a Worker Misclassification Problem?

The company’s lawyer also argued that this was simply a case of worker misclassification. The tax code has a provision for that.

Section 3509 sets the employer’s liability for withholding and Social Security taxes when the employer treated an employee as a contractor. The argument seemed to be that if the payments were really wages, the deduction should be allowed and Section 3509 would handle any payroll tax shortfall.

The tax court did not accept this either. Section 3509 is a payroll tax rule. It sets the employer’s liability when a worker was wrongly treated as a non-employee. It does not turn an unsubstantiated payment into a deductible wage just because the tax code has a mechanism for misclassified workers. And the company offered no evidence that it had misclassified anyone. The owners were already classified as employees. They had W-2s.

So what could the company have done differently? There is a position that the same money, paid as a documented year-end bonus through payroll, would have been deductible. The IRS conceded that the amount of compensation was reasonable. The problem was not the amount. It was the paper. A board resolution approving the bonus, a payroll entry, and a W-2 that reflected the full amount might have told a very different story.

There is also a question the tax court did not reach. If the payments were not compensation, what were they? If they were really distributions, the owners may have reported dividend income as self-employment income and paid employment taxes they did not owe. That might support an amended return or refund claim on the personal side—though the refund statute of limitations may have already run by the time the tax court decides the case. This is why protective refund claims can be useful when a corporate deduction is being litigated and the owners’ returns are tied to the outcome.

The Takeaway

Corporations pay their owners in all sorts of ways. The tax code allows that flexibility. But it does not let a business deduct a payment just because the owner reported it and paid tax on it. The corporation has to prove the payment was for services actually rendered. In this case, the owners were already paid wages for running the business. The extra “subcontractor” payments had no contract, no invoice, no Form 1099, and no testimony describing separate work. That was enough to lose the deduction. If you pay yourself through your corporation, pick one channel and document it. Run owner pay through payroll, or put a real contractor arrangement in writing before the work starts.