The latest edition of Employee Plans News - Issue Number: 2010-06 - August 2, 2010 discusses how an S Corporation cannot deduct expenses for related parties:

If an Employee Stock Ownership Plan (ESOP) owns an S corporation’s stock, that S corporation may not deduct any accrued expenses for any ESOP participant, including retirement plan contributions based on accrued compensation.

Under Code §267(a)(2), a taxpayer, including an S corporation, may only deduct an expense in the same tax year that the payment is reported as income by a related party. Under Code §267(e)(1)(B)(ii), a related party includes any person who directly or indirectly own any of that S corporation’s stock. Therefore, if an ESOP holds an S corporation’s stock, that ESOP’s participants indirectly own stock in the S Corporation. These participants do not include accrued compensation in their income until the year in which they receive it and, therefore, the S corporation cannot deduct any compensation (including any bonus or vacation pay) accrued to these participants. The S corporation also can’t deduct any plan contributions for these participants that are based on accrued compensation.

Any direct or indirect shareholder is considered a related party by IRC Section 267(e) and therefore accrued compensation may not be deducted. You will need to consider this for ESOP purposes, as accrued compensation should not be included in your ESOP allocation and deduction limit calculations:

IRC Section 267 - Losses, expenses, and interest with respect to transactions between related taxpayers

(a) In general

(1) Deduction for losses disallowed

No deduction shall be allowed in respect of any loss from the sale or exchange of property, directly or indirectly, between persons specified in any of the paragraphs of subsection (b). The preceding sentence shall not apply to any loss of the distributing corporation (or the distributee) in the case of a distribution in complete liquidation.

(2) Matching of deduction and payee income item in the case of expenses and interest

If—

(A) by reason of the method of accounting of the person to whom the payment is to be made, the amount thereof is not (unless paid) includible in the gross income of such person, and

(B) at the close of the taxable year of the taxpayer for which (but for this paragraph) the amount would be deductible under this chapter, both the taxpayer and the person to whom the payment is to be made are persons specified in any of the paragraphs of subsection (b), then any deduction allowable under this chapter in respect of such amount shall be allowable as of the day as of which such amount is includible in the gross income of the person to whom the payment is made (or, if later, as of the day on which it would be so allowable but for this paragraph). For purposes of this paragraph, in the case of a personal service corporation (within the meaning of section 441 (i)(2)), such corporation and any employee-owner (within the meaning of section 269A (b)(2), as modified by section 441 (i)(2)) shall be treated as persons specified in subsection (b).

(e) Special rules for pass-thru entities

(1) In general

In the case of any amount paid or incurred by, to, or on behalf of, a pass-thru entity, for purposes of applying subsection (a)(2)—

(A) such entity,

(B) in the case of—

(i) a partnership, any person who owns (directly or indirectly) any capital interest or profits interest of such partnership, or

(ii) an S corporation, any person who owns (directly or indirectly) any of the stock of such corporation,

(C) any person who owns (directly or indirectly) any capital interest or profits interest of a partnership in which such entity owns (directly or indirectly) any capital interest or profits interest, and

(D) any person related (within the meaning of subsection (b) of this section or section 707 (b)(1)) to a person described in subparagraph (B) or (C), shall be treated as persons specified in a paragraph of subsection (b). Subparagraph (C) shall apply to a transaction only if such transaction is related either to the operations of the partnership described in such subparagraph or to an interest in such partnership.

(2) Pass-thru entity

For purposes of this section, the term "pass-thru entity" means—

(A) a partnership, and

(B) an S corporation.