When raise and bonus discussions arise, managers often fail to fully consider the tax implications of such decisions. While an increase in the company’s compensation and payroll tax expense is guaranteed, so too is a corresponding tax deduction, effectively lowering the total cost of the additional compensation by the company’s marginal tax rate. This article explores two additional possibilities that, for some employers, could further reduce the effective cost of compensating employees through additional tax savings. These options do not provide net tax savings to employers, but rather use large tax savings to offset the cost of increasing employee compensation, a critical factor in recruiting and retaining top talent at all levels.

The first option considers the deductibility of reasonable compensation for shareholder-employees. In such a scenario, a raise to all employees, including divided distributions to shareholder-employees, can be less costly than expected after considering the tax savings from avoiding dividend treatment. The other option considers the Domestic Production Activities Deduction (DPAD), which provides an additional 9% deduction of the income generated by qualified production activities in the United States for all entity types. An important limitation on this deduction is that it cannot exceed 50% of the W-2 wages paid to employees involved in the qualified activity. For businesses with low employee compensation costs relative to income (e.g., due to automation or high capital investment), an increase in this limitation, accomplished by raising employee wages, may further reduce the cost of marginal pay.

Shareholder-Employees and Reasonable Compensation

Shareholder-employees of successful companies often prefer to receive higher salaries, which are deductible by the corporation, rather than receive dividends, which, while generally taxed at lower rates, provide no tax benefit to the corporation. Substantiating higher compensation for services as opposed to distributions of profits is a particularly sticky area. Reasonable compensation of shareholder-employees is an important area of audit for the IRS, which has regulatory authority to reclassify compensation that is not substantiated as dividends (and vice versa).

Internal Revenue Code (IRC) section 162(a)(1) provides a two-prong test for the deductibility of compensation provided to any employee. First, the amount of compensation must be reasonable; second, payments must be purely for services performed by the employee. The latter test is generally assumed to be satisfied absent evidence to the contrary for other employees, but is subject to additional scrutiny for shareholder-employees. Similarly, reasonable compensation is subjective in nature, though, provided no violation of the arm’s-length transaction has taken place, it is reasonable to assume that companies would not pay employees more than necessary. Again, evaluating the reasonableness of a payment to shareholder-employees provides a window for disagreement between the IRS and taxpayers.

Because of the subjectivity of reasonableness of compensation, this matter is not foreign to the courts. More than 30 years ago, the Ninth Circuit of the U.S. Court of Appeals, in Elliotts, Inc. v. Comm’r, (CA-9 1983), provided five factors for establishing reasonable compensation:

  • Employee’s role in the company
  • External comparison of salaries
  • Character and condition of the company
  • Conflict of interest
  • Internal consistency.

The first factor looks at the position held by the employee, hours worked, and duties performed—in essence, how important the employee is to the overall success of the company. The second factor calls for a comparison between the employee’s compensation and the compensation of an employee who performs similar services for a similar company. The third factor delves into the company’s size based on financial performance metrics, as well as the complexity of the company and general economic conditions.

Shareholder-employees of successful companies often prefer to receive higher salaries, which are deductible by the corporation, rather than receive dividends, which, while generally taxed at lower rates, provide no tax benefit to the corporation.

A company can establish these first three factors relatively easily based on facts and documentation alone, but the fourth and fifth factors are difficult to objectively measure. The fourth factor, conflict of interest, requires viewing the company and its compensation policies from the viewpoint of an independent, third-party investor, as clearly a shareholder-employee in a closely held corporation is biased when determining his own compensation for services, according to the decision in Elliotts. The Seventh Circuit further emphasized the importance of this “independent investor” idea, saying it was the lens through which all factors should be reviewed, in Exacto Spring Corp. v. Comm’r [196 F.3d 833 (7th Cir. 1999)]. The court found that if investors were receiving “a far higher return than they had reason to expect,” compensation is presumed reasonable. Applying this principle in a recent case, H.W. Johnson, Inc. v. Comm’r (TC Memo 2016-95), the court asserted that a return on equity of 10% is a reasonable expectation for investors, provided that there is no evidence to the contrary. Considering this relatively low threshold, and the fact that compensation resulting in ROE less than 10% has also been found reasonable (i.e., Multi-Pak Corp. v. Comm’r, TC Memo 2010-139), establishing no conflict of interest exists based on the compensation is less difficult for many shareholder-employees.

The fifth and final factor, internal consistency, requires that all employees be compensated based on the value of services performed and that the internal compensation policy is consistently applied. Specifically, the company needs to be able to show that the policy does not favor shareholder-employees in any way. Like the conflict of interest factor, this factor is more subjectively measured than the first three, and an important consideration is compensation of nonshare-holder-employees.

With the first four factors met, paying employees above-market wages may help justify additional shareholder-employee compensation. For example, in a closely held corporation that has recently become more profitable, owners could increase transfers to the shareholders, but doing so as dividends creates no tax savings while costing shareholders a tax of as much as 23.8%. Increasing compensation to shareholder-employees instead may, however, violate internal consistency. If the company increases wages across the board instead, internal consistency is satisfied, opening the door to treating the transfer as additional compensation to shareholder-employees. While the total cost of additional compensation to the other employees will exceed the tax savings, the effective cost of offering the additional pay is now not only reduced by the amount of the traditional deduction for compensation, but additional tax savings are also realized by deducting the shareholders’ payments.


Exhibit 1 illustrates how a company may cost-effectively give its employees raises while still establishing each of the five factors necessary to show reasonable compensation. Assume a closely held C corporation with five shareholder-employees faces a 35% marginal tax rate and a total payroll tax rate of 11.35%, including the Federal Insurance Contributions Act (FICA), the Federal Unemployment Tax Act (FUTA), and state unemployment. In recent years, each shareholder-employee received $200,000 in wages and an additional $100,000 in dividends, though all would prefer to receive additional compensation in lieu of dividends if possible to avoid double taxation. The company has won a large, multiyear contract, providing surplus gross profit that the owners believe should be reinvested in the company. Each of the five shareholder-employees agrees to continue receiving $300,000 in total compensation per year. Because the corporation is closely held, the shareholder-employees consider taxes paid by the corporation or by the shareholders equivalent, and prefer to minimize the total tax outlay.

Exhibit 1

Net Cost of 15% Raise to All Employees When Shareholder-Employees Receive Dividend Income

Assumptions:; # of shareholder-employees; 5 Corporate marginal tax rate; 35% Corporate payroll tax rate; 5.15% Corporate Social Security rate; 6.20% Employee payroll tax rate; 1.45% Shareholder-employee tax rate; 28% Employee dividend tax rate; 15% Compensation; Pre-Raise; With Raise; Difference Shareholder-employee wages; $1,000,000; $1,150,000; $150,000 Shareholder-employee dividend; $500,000; $350,000; ($150,000) Total shareholder-employee compensation; $1,500,000; $1,500,000; - Wages—other employees; $2,000,000; $2,300,000; $300,000 Total compensation; $3,500,000; $3,800,000; $300,000 Corporate tax Payroll taxes—shareholder-employees; $51,500; $59,225; $7,725 Payroll taxes—other employees; $227,000; $261,050; $34,050 Total corporate tax; $278,500; $320,275; $41,775 Corporate tax shelter; ($1,147,475); ($1,319,596); ($172,121) Shareholder-employee's tax Payroll tax; $14,500; $16,675; $2,175 Income tax; $280,000; $322,000; $42,000 Tax on dividends; $75,000; $52,500; ($22,500) Total shareholder-employee tax; $369,500; $391,175; $21,675 Net taxes paid; ($499,475); ($608,146); ($108,671); Total compensation paid; $3,500,000; $3,800,000; $300,000 Total taxes paid; $648,000; $711,450; $63,450 Corporate tax shelter; ($1,147,475); ($1,319,596); ($172,121) Net paid; $3,000,525; $3,191,854; $191,329 Cost per dollar; $0.64

As part of its reinvestment in the company, the corporation improves its compensation package, giving all employees a 15% raise. Each shareholder-employee receives $30,000 in additional compensation subject to payroll taxes, but avoids double taxation on this $30,000 with a reduced dividend of $70,000. Assuming the other four factors for reasonable compensation are met, this across-the-board raise changes the internal compensation structure, and the shareholder-employees do not receive preferential treatment. While this approach results in the company having increased salary and payroll tax expense, this is partially offset by the additional deduction for $150,000 paid to shareholder-employees that was previously nondeductible. Even after considering the effects of the additional payroll tax and higher ordinary income rate of the shareholder-employee, the additional deduction at the corporate level provides an overall net tax savings of $108,671 on the $300,000 increase, which reduces the cost of the raise to just $.64 per dollar. While many owners would balk at the gross cost of an across the board raise for employees, this analysis of the potential tax savings reveals how different the actual costs will be.

The DPAD W-2 Limitation

Another opportunity for incremental tax savings to offset the cost of increasing compensation can be found in IRC section 199, commonly referred to as the Domestic Production Activities Deduction (DPAD). First enacted in 2005, the DPAD allows businesses, regardless of entity type, an additional deduction based on the income created through production of products (among other things) in the United States. While domestic manufacturing activities are the primary beneficiary of the DPAD, the law liberally defines “domestic production activities” to include mining, oil extraction, farming, construction, architecture, engineering, and the production of software, recordings, and films. The activity must qualify as a trade or business and therefore be engaged in regularly by the taxpayer.

The DPAD is calculated as 9% of the qualified production activities income (net of expenses), but is subject to two important limitations: 1) 9% of taxable income for C corporations, or AGI for sole proprietors, owners of partnerships and LLCs, and S corporations; and 2) 50% of Form W-2 wages paid to employees involved in the qualified production activity. The latter limitation serves to cap the benefit of the DPAD for enterprises engaged in qualified activities that use minimal labor in their processes. As automation continues to minimize the role of labor in production processes, this limitation frequently limits the size of the DPAD. In this scenario, however, increasing employee compensation by $1 increases the limited DPAD of the company by $.50, further reducing the cost of the additional compensation to the employee.


Assume a DPAD-eligible corporation has qualified production activity income of $1.03 million and a taxable income of $1.2 million. Absent the W-2 limitation, the corporation’s DPAD would be $92,700 ($1.03 million × 9%). The process employed for production, however, is highly automated and uses only three employees, at a total W-2 labor cost of $150,000; therefore, the DPAD will be limited to $75,000 ($150,000 × 50%). If the corporation gives each of the three laborers a $10,000 annual raise, the ordinary business expense deduction for compensation of the $30,000 cost reduces qualified production activity income to $1,000,000, but the company will receive an additional $15,000 DPAD deduction because the W-2 limitation will no longer apply and the new $90,000 DPAD will be fully deductible [($1,030,000 − $30,000) × 9%]. Using the payroll tax and marginal tax rates from the scenario above, the $30,000 raise will result in a total outlay of $3,405 in payroll taxes ($30,000 × 11.35%), an $11,692 tax savings from the compensation deductions [($30,000 + $3,405) × 35%], and an additional DPAD deduction of $15,000, for a tax savings of $5,250 ($15,000 × 35%). Netting the costs and tax savings yields a startling result: the company’s raise of $30,000 costs it only $16,463, or less than $.55 on the dollar.

Exhibit 2

Net Cost of Raise When DPAD Is Limited by Employee Wages

Assumptions: QPAI; $1,030,000 Taxable income; $1,200,000 # of employees; 3 Marginal tax rate; 35.00% Payroll tax rate; 11.35% DPAD calculation:; Pre-Raise; With Raise; Difference QPAI; $1,030,000; $1,000,000; - QPAI rate; 9%; 9%; - Potential DPAD; $92,700; $90,000; - W-2 wages; $150,000; $180,000; $30,000 Wages limitation; 50%; 50%; - DPAD limitation; $75,000; $90,000; $15,000 Allowable DPAD; $75,000; $90,000; $15,000 Additional wages paid; $30,000 Additional payroll taxes; $3,405 Tax savings from additional wages deduction; ($10,500) Tax savings from additional payroll tax deduction; ($1,192) Tax savings from additional DPAD deduction; ($5,250) Net cost of raise; $16,463 Cost per dollar; $0.55 DPAD =Domestic Production Activities Deduction QPAI=Qualified Production Activities Income

Competing for Talent

The scenarios presented above detail two situations where tax benefits beyond the expected business expense deduction can partially offset the cost of increasing employee compensation. An increase in compensation often yields important benefits; current employees may be more motivated to work in order to retain their positions, recruitment of quality employees may be easier, and retention of key workers may be improved, resulting in increased productivity and reduced turnover and hiring costs. While the federal income tax will never fully subsidize the cost of compensating employees, a keen awareness of situations such as these can be a competitive advantage in a tight labor market.

While some tax incentives, such as the Work Opportunity Tax Credit, may be applicable to a wide berth of companies, the benefits presented here are subject to important caveats. In the first scenario, the corporation must first have the means to provide raises to all employees, and shareholder-employees must have already maxed out their pay relative to dividends under the current compensation structure. This scenario may seem unusual, but for closely held corporations, shareholder-employees often seek transfers from the corporation in excess of what their employment would merit. In the case of the DPAD, many taxpayers of varying entity forms qualify when engaged in qualified production activities that employ workers. With increasing reliance on technology, automation, and outsourcing, W-2 wages as a percentage of gross profit are generally declining. This will lead to more W-2 wage-restricted DPADs; in this scenario, companies can maximize the deduction by paying their employees more, which in turn greatly offsets the cost of the raise. While the examples presented in this article are not applicable to all employers, the importance of considering taxes when setting employee compensation strategy will only grow over time.

John Ledbetter, PhD, CPA is an associate professor of accounting at Ball State University, Muncie, Ind.
Jason Stanfield, PhD, CPA is an assistant professor of accounting at Ball State University, Muncie, Ind.
Elizabeth Paulus, CPA is a staff accountant at Katz, Sapper, & Miller, Indianapolis, Ind.