"Loans from Shareholders" category, S-corp

[G2R]

New client, 20 years in business as an S-corp. 

• 2021 ending M-2 shows a large loss.
• The one and only balance sheet I could find was the 2020 1120S which had a very large balance in "Loans from Shareholders."  Client knows nothing about any loans outstanding, so no loan documents.
• They actually had all past K-1s. K-1s only list the income/losses each year.  No distributions were reported. Losses were all taken on the personal return each year.
• No basis history was provided so I have to rebuild it as best I can.

For me to get 2022 on the right path, would you simply reclassify the loan from shareholder to capital?  

Also, there's a truck on the books that the company doesn't own, yet was depreciated the last two years. Do I get it off the books as if it was converted to personal use in 2022?  It was definitely used for the business, but no mileage logs were kept.   

[jklcpa]

I wouldn't do anything yet without more information because I've followed some creative predecessors and clients that give incorrect answers.

A typical audit scenario in textbooks is when the auditor discovers assets or expenses on the books or returns that can't be traced back to the only cash account and may indicate other hidden cash accounts and activity.  I'm not saying this is your client though.

Something else comes to mind that I've actually seen is when a client uses a personal vehicle for business and trades it for a new one with that new vehicle titled in the business name, thinking of all the deductions it could create. Have you seen the title, registration document, or insurance bill listing the vehicle?  Perhaps the prior accountant was creative and booked the vehicle and "loan from shareholder" was the balancing entry of the trade-in value of the personal vehicle and/or new vehicle's loan payments being paid personally.

[Lee B]

Can the client provide any financial statements or a trial balance for any of the years?

What information did the client provide every year to whomever prepared the tax returns?

Can the client go back to the prior tax preparer and obtain complete tax returns?

[G2R]

Same accountant for the last 20 years who didn't seem to mind all the comingling that was going on.  No more comingling going forward.

The 7203 on last year's personal return shows shows zero beginning balance, a $50k contribution (client's know nothing about this so I think this was just plugged in there), and a small positive ending value so the IRS has an ending basis in their records already if they are actually tracking the 7203. Nothing listed in the Debt Basis even if the loan from shareholders was accurate. Not sure how to correct this either.  But based on the K-1s I have and all the comingling, they have been personally funding the losses for decades.   

1 hour ago, jklcpa said:

Have you seen the title, registration document, or insurance bill listing the vehicle?  Perhaps the prior accountant was creative and booked the vehicle and "loan from shareholder" was the balancing entry of the trade-in value of the personal vehicle and/or new vehicle's loan payments being paid personally.

I confirmed, title of the car, insurance and license are definitely in the owner's name, not the business.  I do think your suggestion is exactly what happened.  Along with ALL the other expenses the owner paid for the business with personal funds. 

1 hour ago, cbslee said:

Can the client provide any financial statements or a trial balance for any of the years? What information did the client provide every year to whomever prepared the tax returns? Can the client go back to the prior tax preparer and obtain complete tax returns?

No trial balance was ever done that I can find. Client provided a P&L only, that's what accountant used to prep the returns all 20 years. I have all 20 years of tax returns.  The M-2s match the balance sheet R/E for each year. The previous accountant is deceased.

To move forward:

• can/should I recategorize the loans to capital?  
• how can I properly remove the vehicle from the books?  It's not even 100% used for business, though they only took the generic 50% usage and depreciation deduction in the years since purchase.   

[Abby Normal]

Does the entity even have books? If not, I'd send them packing. Not worth the trouble.

[G2R]

50 minutes ago, Abby Normal said:

Does the entity even have books? If not, I'd send them packing. Not worth the trouble.

I've made it clear what I expect of them moving forward. They are more than willing to obliged it seems, they have just never had an accountant educate them on what is truly needed to have proper records. They want to do it right so I'm doing my best to get them on the right course. 

[Medlin Software, Dennis]

Nothing being distributed, which could be true if they are loaning money to the corp every year with no payoff>  Could be true the business has yet to make money and the owners keep funding the loss.  Could be a need to look for some sort "other" distribution, such as personal expenses or things which should have been personal expenses.

Just the feelings from an old jaded hand... who has seen similar (and nuttier) before.

[Lee B]

23 hours ago, G2R said:

Same accountant for the last 20 years who didn't seem to mind all the comingling that was going on.  No more comingling going forward.

The 7203 on last year's personal return shows shows zero beginning balance, a $50k contribution (client's know nothing about this so I think this was just plugged in there), and a small positive ending value so the IRS has an ending basis in their records already if they are actually tracking the 7203. Nothing listed in the Debt Basis even if the loan from shareholders was accurate. Not sure how to correct this either.  But based on the K-1s I have and all the comingling, they have been personally funding the losses for decades.   

I confirmed, title of the car, insurance and license are definitely in the owner's name, not the business.  I do think your suggestion is exactly what happened.  Along with ALL the other expenses the owner paid for the business with personal funds. 

No trial balance was ever done that I can find. Client provided a P&L only, that's what accountant used to prep the returns all 20 years. I have all 20 years of tax returns.  The M-2s match the balance sheet R/E for each year. The previous accountant is deceased.

To move forward:

• can/should I recategorize the loans to capital?  
• how can I properly remove the vehicle from the books?  It's not even 100% used for business, though they only took the generic 50% usage and depreciation deduction in the years since purchase.   

If it was my client, first I would nail down all the balance sheet accounts as of last year end to the best of my ability.

I would use a 3115 to correct the vehicle depreciation, then remove the vehicle from the balance sheet at the original cost.

Then the remaining loan balance as of last year end should be reclassified to APIC.

Good Luck, you have a lot of work ahead of you.

 

[Abby Normal]

22 hours ago, G2R said:

I've made it clear what I expect of them moving forward. They are more than willing to obliged it seems, they have just never had an accountant educate them on what is truly needed to have proper records. They want to do it right so I'm doing my best to get them on the right course. 

They're lying. Anything less than a total reconstruction from the beginning of time would be inadequate, and they won't want to pay for that.

[Lee B]

39 minutes ago, Abby Normal said:

They're lying. Anything less than a total reconstruction from the beginning of time would be inadequate, and they won't want to pay for that.

Whether or not they are lying, a total reconstruction is almost impossible. If you are going to take on a client like this,

the best you can do is nail down all the balance sheet accounts and move forward. 

[Corduroy Frog]

Truth is, ALL of us have had new customers with difficult circumstances.  I believe if we back away simply because of difficulty, we are beguiling our calling as tax professionals.  There are most likely some of us who fear the possible liability, and that is a business decision incumbent on each of us.

Having said that, there are some situations I won't engage.  Potential customers who are obviously lying, customers who switch preparers because they haven't paid last year's bill, etc.  But for difficulty?  I won't back away if there is any way to make the client well going forward.

Our blonde colleague from Florida definitely has a train wreck.  I agree with CBS, establish a balance sheet that will enable future compliance.  And explain that it will require extra work, and don't go too deep without getting paid.  

 

[G2R]

Thank you everyone for the advice and professional experience.  I really appreciate it.

Curious thought.  The amount listed as loans from shareholders is way over the $25k open account limit. Is there any value in reclassifying all of the loan to shareholder to APIC except for $25k?  It will be paid off by end of this year.

[DANRVAN]

On 8/22/2023 at 3:22 AM, G2R said:

Also, there's a truck on the books that the company doesn't own, yet was depreciated the last two years. Do I get it off the books as if it was converted to personal use in 2022? 

Depends.  Did company pay with cash or making payments?  If it has only been two years I would consider amending to properly account for during that time period.

 

On 8/22/2023 at 3:22 AM, G2R said:

Client knows nothing about any loans outstanding, so no loan documents.

 

4 hours ago, G2R said:

It will be paid off by end of this year.

Those two statements do not line up.  

[Lee B]

5 hours ago, G2R said:

Thank you everyone for the advice and professional experience.  I really appreciate it.

Curious thought.  The amount listed as loans from shareholders is way over the $25k open account limit. Is there any value in reclassifying all of the loan to shareholder to APIC except for $25k?  It will be paid off by end of this year.

Earlier you implied that the owner has been funding losses for decades. If so how would they be able to repay the $25,000?

[G2R]

 

52 minutes ago, DANRVAN said:

Those two statements do not line up.  

6 minutes ago, cbslee said:

Earlier you implied that the owner has been funding losses for decades. If so how would they be able to repay the $25,000?

The first statement was referencing debt from shareholder that had supposedly grown through 2021, but no formal loan docs had ever been made.  Owner didn't know it was necessary. So, as of Jan 1 2022, all previous loans from shareholders to the company would be reclassified as APIC. 

For 2022 books, the second statement referenced the possibility of open account debt as of Dec 31, 2022, that stays within the $25k limit.  2023 is looking rather profitable thus far so, he could pay off that debt by year end, not have the formal loan docs requirement and the reimbursements to him wouldn't be considered return of capital.  

 Just throwing the idea out there for opinions.  

[mcb39]

I could probably write a book on this subject, but I won't.  Mine is a 50 year old Partnership wherein one partner often funds purchases when cash is low.  I never add it to his Capital Account; but I carefully document his Cash In and Cash out when the particular item of stock is sold.  The profit stays with the Partnership.  The only time I show it as an outstanding loan is if there is one that has not been repaid at the end of the year.  I have done their bookkeeping and tax returns since 1972 and the IRS has never questioned a thing.  You might call this creative accounting; but it works and the simpler you keep things, the better.  I will add that this is a family owned Partnership which could (might) make a difference.  I can only stress the importance of documentation and this poor fellow doesn't seem to have that to fall back on.

[Medlin Software, Dennis]

1 hour ago, mcb39 said:

I could probably write a book on this subject, but I won't.  Mine is a 50 year old Partnership wherein one partner often funds purchases when cash is low.  I never add it to his Capital Account; but I carefully document his Cash In and Cash out when the particular item of stock is sold.  The profit stays with the Partnership.  The only time I show it as an outstanding loan is if there is one that has not been repaid at the end of the year.  I have done their bookkeeping and tax returns since 1972 and the IRS has never questioned a thing.  You might call this creative accounting; but it works and the simpler you keep things, the better.  I will add that this is a family owned Partnership which could (might) make a difference.  I can only stress the importance of documentation and this poor fellow doesn't seem to have that to fall back on.

Family deals are the ones to worry about the most - to me. Lack of usual practices seem to always come back for a big bite at some point. I guess I have seen the demise of too many family entities because of lack of planning and documentation.  The old "if it is not written, it does not exist" line has a purpose.

What if the partner acting as the bank passes and the remaining partners and heirs differ on the existence of any loan balance?

[Lee B]

The key question is, "When do you cross the line from the proper recording of client transactions to making decisions which should be made by your client?"

[Medlin Software, Dennis]

2 hours ago, cbslee said:

The key question is, "When do you cross the line from the proper recording of client transactions to making decisions which should be made by your client?"

Perfect point. Rereading the OP, sounds like more than a preparer relationship is being expected.

[mcb39]

4 hours ago, cbslee said:

The key question is, "When do you cross the line from the proper recording of client transactions to making decisions which should be made by your client?"

I don't believe that I have crossed any lines.  Because these Partners are my husband and two sons.  I am not a Partner; however I make many of the financial decisions for them.  I have even been "the Bank" at times.  Every single transaction that occurs is carefully documented; posted and backed up.  I also have an assistant doing the balancing of the checkbook and the posting of the transactions so that there are always two heads in the works.  Every single transaction, deposit, expense and disbursement has been recorded, backed up and saved for all 50 years.  I wouldn't be doing this for just any client; but I have several business clients and I always want to know as much as possible and tutor them on the proper recording of all transactions.  My worry has always been that if something happened to me, who would know the status of my family's business. None of them would have a clue. That is why I brought in a third party to get to know how things flow.  In the case when I have been the bank; an amortization schedule was created; I charged interest and 1099d myself for interest received.  When my son makes cash donations to cover large purchases; it is clearly noted as Cash In and Cash out when the item sells.  The year end Balance sheets and Cash Flow reports clearly show this.

I know this has gotten far away from the OP, but I was just trying to show how things can be done without creating chaos.  Perhaps Judy should remove the thread from my first post on down.

Their business is their business and mine is mine, which makes for one of the most extensive tax returns that I do and is usually one of the last.

[schirallicpa]

The accountant needed a credit and put it to shareholder loan.  I suspect the credit is unreported sales.  Clients always make sure they keep track of every expense they can take.  Somehow they forget to account for all the income needed to pay for it.