P is a U.S. corporation that owns 100% of S, a U.S. corporation. P established a bonus program for S’s employees and, under that program, P pays cash bonuses each December directly to S’s employees for their past services performed for S during the calendar year. None of these employees perform any services for P.
The Actual Transaction panel shows what happens on the ground: P writes the checks directly to S’s employees, even though the employer/employee relationship runs between S and those employees, not between P and them. Because P is not the employer and received no services, P cannot simply deduct the bonuses as its own compensation expense.
The Deemed Transactions panel shows the two-step recharacterization the ruling imposes. First (step a), P’s payment is treated as a contribution to the capital of S — a nondeductible investment by P in its subsidiary that increases P’s basis in the S stock. Second (step b), S is treated as constructively paying the cash bonuses to its own employees. Because of that deemed contribution and constructive payment, the bonuses may be deducted by S under section 162 of the Code, provided each employee’s total compensation is reasonable for the services performed.
The right to the compensation deduction belongs to S, the employer that received the services, even though P actually cut the checks to the employees.
P’s direct payment is split into a deemed contribution to S’s capital, followed by a constructive payment of the bonuses by S to its employees.
P gets no compensation deduction; instead its outlay is a nondeductible contribution to capital that increases P’s basis in the S stock.
S may deduct the constructively paid bonuses under section 162, so long as each employee’s total compensation is reasonable for the services rendered.
