Retroactive S-Corp payroll?

[HV Ken]

Was in a conversation with another preparer about a new S-Corp client s/he picked up (after deadline, on extension). That particular discussion relates to Scenario 1, and also made me think about Scenario 2. In both scenarios, S-Corp is single shareholder and no payroll in 2013.

Scenario 1:

Client had a very good year and should have been on payroll.

Scenario 2:

Client's only income is via S-Corp K-1 and is low enough that if client had any earned income (i.e. W-2), client would qualify for EIC.

Has anyone ever filed a "retroactive" (late) payroll in either of these cases (just for 4q, for example)? Assume client is fine with late filing penalties, etc.

Not something I have ever thought about, but other preparer was floating this idea.

Note - while it is certainly interesting to hear of other tax strategies (feel free to share as well) you may use in either scenario - I am curious on people's thoughts, reactions, risks, exposures, etc. to this particular idea.

Thanks!

[Jack from Ohio]

Not even a consideration. The IRS would LOVE to get that. You cannot backdate payroll.

Run Forrest Run!!

[HV Ken]

Not even a consideration. The IRS would LOVE to get that. You cannot backdate payroll.

Other than the payroll being filed late, how would they know this was "retroactive" vs. late?

For example

Owner used payroll company in 2012 and decided to cancel for 2013 and do it themselves (they are cheap!), but they didn't realize they need to file 940x (and state) returns, etc. They get notices from IRS (or state) about forms expected but not filed, come to an accountant crying "help" and accountant gathers the data from owner and files the forms late (in 2014).

vs.

File "retroactive" payroll numbers in 2014 for 2013.

Won't these two very different courses of action look the same?

[NECPA in NEBRASKA]

One difference would be if it were not retroactive and they had just forgotten to file payroll taxes, the paychecks would have been cleared. My cousin's wife didn't file or pay his payroll taxes for years, but the payroll checks were written and cleared in a timely manner.

[Jack from Ohio]

Paycheck dates MATTER if the IRS looks. And in this situation, they WOULD look.

Payroll cannot be back-dated. It has to be "constructively received" in the year it is claimed as expense.

I think the work "fraudulent" would fit here. If the preparer is knowledgeable of this, and they choose to go forward with it, they will be as liable as the company owners.

If the S-Corp owner had consulted with an experienced and ethical tax preparer, you would not even be asking this question.

[michaelmars]

in scenario 1 if there were distributions then I would have no issue with making them payroll since that is what the irs would do on an audit. scenario 2, if there were no real distributions I would not make them up.

[JohnH]

I agree. If there were cash distributions, then they can easily and legally be reclassified as payroll by grossing up the figures. But if there were no cash distributions, then there's no basis for just making up figures.

But if reworking the figures generates EIC, that might be a land mine.

I wouldn't go anywhere near that...

[HV Ken]

in scenario 1 if there were distributions then I would have no issue with making them payroll since that is what the irs would do on an audit. scenario 2, if there were no real distributions I would not make them up.

Interesting point Michael. In the other post I made where the client's S election was not accepted for 2014, the IRS reply included the following text:

We'd also like to take this opportunity to remind you of your tax obligations for the payment of compensation to shareholder-employees of S corporations.

When a shareholder-employee of an S corporation provides services to the S corporation, the S corporation must reasonably compensate the shareholder-employee. This compensation is subject to employment taxes.

The IRS may re-characterize distributions as salary. This position has been supported by Revenue Ruling 74-44 and in numerous court decisions.

So if the IRS can retroactively convert distributions to payroll, why would an accountant proactively doing this be considered conducting a fraudulent practice as Jack contends?

It would seem the preparer should get a look at the books (not just the printed reports) before considering this approach.

[GeneInAlabama]

Other than the payroll being filed late, how would they know this was "retroactive" vs. late?

YOU would know!

[jshtax]

Why not move the distributions to an expense and pick up the distributions as income on schedule C?

[OldJack]

Why not move the distributions to an expense and pick up the distributions as income on schedule C?

By definition an officer of a corporation is an "employee" which is why the IRS has the authority to reclassify officer distributions as salary. So what "employee expense", other than salary expense, would you classify it on the corp tax return?

[michaelmars]

we have done this in the past and from an irs point of view there is no difference except for unemployment insurance which is a nominal amount. afterall doing the sch c way and if irs makes you change it to payroll the net taxes are the same. Not a good way to go but not a bad argument for doing it this way at least once till the client gets educated. If you go this way, file the 1099 although late. this way there is no attempt to hide what you did.

[OldJack]

>> after all doing the sch c way and if irs makes you change it to payroll the net taxes are the same. <<

1. You have no reason to believe that the IRS will agree net taxes are the same and could treat things separate and charge penalties.

2. On the Corp tax return you have an "expense" that is not ordinary and necessary, could be treated as a distribution of capital or dividends, therefore not deductible. IRS interest and penalties for underpayment of tax.

3. If the "expense" is reclassified as a dividend you have no deduction to the corporation but income to the 1040, therefore no amendment or change to 1040 taxable income.

4. If the 1040 must be amended you have opened the individual to possible other related tax disclosures on audit exam.

You are really gambling that an IRS auditor will agree with you. If I was an IRS auditor I would not agree with you.

[Jack from Ohio]

>> after all doing the sch c way and if irs makes you change it to payroll the net taxes are the same. <<

1. You have no reason to believe that the IRS will agree net taxes are the same and could treat things separate and charge penalties.

2. On the Corp tax return you have an "expense" that is not ordinary and necessary, could be treated as a distribution of capital or dividends, therefore not deductible. IRS interest and penalties for underpayment of tax.

3. If the "expense" is reclassified as a dividend you have no deduction to the corporation but income to the 1040, therefore no amendment or change to 1040 taxable income.

4. If the 1040 must be amended you have opened the individual to possible other related tax disclosures on audit exam.

You are really gambling that an IRS auditor will agree with you. If I was an IRS auditor I would not agree with you.

Two Jacks agree on this one.

[JohnH]

It's an S corporation. There's no issue with dividends or double taxation. That would only come into play with a C corp or in the extremely unlikely event there are retained earnings locked up in the S corp from prior operation as a C corp.

And I doubt an auditor would make any adjustment, provided things are handled correctly going forward.

But I'd still stay away from any reclassification (either via Schedule C or via retroactive payroll), if it produced EIC.

[OldJack]

It's an S corporation. There's no issue with dividends or double taxation. That would only come into play with a C corp or in the extremely unlikely event there are retained earnings locked up in the S corp from prior operation as a C corp.

And I doubt an auditor would make any adjustment, provided things are handled correctly going forward.

But I'd still stay away from any reclassification (either via Schedule C or via retroactive payroll), if it produced EIC.

Yes, if it is an S-corp a non-deductible expense increases flow-thru taxable income to the shareholder and the shareholder already has a 1040 Sch-C income equal to the expense resulting in duplicate income. Agree that most IRS auditors are not bright enough to think of non-deductible expense and duplicate income. Sometimes it just might be better to let a dead dog lie until the stink is gone.

[michaelmars]

non deductible is the way the original return was reported by calling them distributions. changing to payroll would result in lower income but would be balanced out by the wage income or [sch c] so the net is the same but now fica woiuld be getting paid on the money. distributed.

[JohnH]

Yes, if it is an S-corp a non-deductible expense increases flow-thru taxable income to the shareholder and the shareholder already has a 1040 Sch-C income equal to the expense resulting in duplicate income. Agree that most IRS auditors are not bright enough to think of non-deductible expense and duplicate income. Sometimes it just might be better to let a dead dog lie until the stink is gone.

Interesting, but I'm not processing this in the same way. In the extremely unlikely event that the auditor classified the distribution as a non-deductible expense of the corporation, what tax preparer would not think of amending the personal return and deleting the Schedule C? IRS can't have it both ways in this situation.

[mircpa]

If distributions were made, file payroll reports. I had this scenario with one of my client when IRS audited looked at checks he wrote for himself from corporation, IRS swiftly made him file 941's retroactively for 2 years audit period in question. Regardless of any situtation whether retroactive or current 941 needs to be filed. I agree with michaelmars.

[OldJack]

Interesting, but I'm not processing this in the same way. In the extremely unlikely event that the auditor classified the distribution as a non-deductible expense of the corporation, what tax preparer would not think of amending the personal return and deleting the Schedule C? IRS can't have it both ways in this situation.

Of course the taxpayer would file amended 1040, but you miss the point that penalties can be assessed and the "tax preparer" would end up reimbursing the client for his wrongful filing.

[JohnH]

Of course the taxpayer would file amended 1040, but you miss the point that penalties can be assessed and the "tax preparer" would end up reimbursing the client for his wrongful filing.

OldJack:

I'm still interested in your line of thought.

The corporation would not incur any penalties because it incurs no tax liability.

Income on the 1040 would be essentially the same after all the dust settled.

What penalties would/could be assessed?

(And how would they compare to the reduction of 15% Self-employment tax?)

[OldJack]

OldJack:

I'm still interested in your line of thought.

The corporation would not incur any penalties because it incurs no tax liability.

Income on the 1040 would be essentially the same after all the dust settled.

What penalties would/could be assessed?

(And how would they compare to the reduction of 15% Self-employment tax?)

Check out IRC 6722 and Small Business Quickfinder Handbook page 1 of S-Corp tab regarding "incorrect information" on Sch K-1. The max post-2011 penalty ranges from $75,000-$500,000. Minimum would be $30-60 per K-1 failure.