S-Corp Question

[Terry D EA]

Single sharehold of a new S-Corp assumed it was okay to take "draws" without being an employee. He has asked me to prepare his 2007 tax return. The company is a June 30 fiscal year company. This will be the first tax return. I have advised him to become an employee of his own S-Corp because he does materially participate. How would any of you handle this? Just record his "draws" as officer salary? He has employees who have had the withholdings done correctly. I am concerned about the red flag this will throw up and don't want to be connected as guilty when it does because I have knowledge of what he has done. My thoughts are for him to pay the required taxes and make the withholding payments by correcting the June 30 941 and face the penalties. What would any of you do??

Thanks,

Terry D.

[samingeorgia]

First, you'd better look at the correspondence he has received from IRS; I really doubt that he has an S corp. with a June 30 year-end.

It's more likely that the year end is December 31, and if that's the case, you have time to get the draws reclassified as salary. Of course, if the company isn't profitable, he may just be withdrawing his own money or the bank's (!).

[jainen]

>>without being an employee<<

Corporate officers are employees by definition. He can ignore that fact, but he can't escape it.

[joelgilb]

He can get away with reducing his salary by taking a portion of it as draws, but not eliminate it.

I went to a seminar taught by IRS Appeals Officers that informed the class that IRS accepts this position and often will accept as much as 50% draw vs salary or possibly more from S-Corp shareholders. In fact to the surprise of all, they recommended it!

Might be enough if you give him a bonus for the end of the year and and treat that as payroll, withholding accordingly. And this would reduce exposure. Next year you can adjust between the 2 in a more appropriate fashion.

[kcjenkins]

I'm wondering about that fiscal year for an S corp, myself. But if this is the first year of business, delaying his 'salary' could be easily defended for that first year. Especially if you get him onto payroll going forward. While he is, by definition, an 'employee', he can be a $1 a year employee until the business is established and profitable. Of course, if he's making buckets of money, and pulling out significant draws, then you do need to get him some salary into the last quarter of this calender year, at least.

[OldJack]

>>he can be a $1 a year employee <<

I agree! If the big 3 motor company executives can get away with only taking $1 salary so should anyone else. However, I have clients that are showing $1,000 gross taxable on their W2.

Actually, if the first year S-corp is NOT reporting a profit he would not have to take a salary as was pointed out he would just be taking back some of his investment.

[Terry D EA]

Thanks to all who responded. Old Jack and KC, I can always count on you guys to give a good answer. The books show a loss for the first year. However, that loss is due to the shareholder deducting his "draws". He now shows that he withdrew 56,900 w/o any payroll taxes. I have asked for the documentation from the IRS regarding the S-election. Remember I stated an attorney filed the Articles of Incorporation and the S-election according to my client who says he wasn't told anything.

At this time, I estimated the payroll taxes he should have paid, told him I would find out how to correct the the last quarter 941. I know you can't file 941-C with a quarter this year to correct a previous year. So, any help here would be appreciated. I also told him, that I had to proceed in the correct manner and would not advise him any other way.

I don't think the $1.00 thing would fly to well considering his draws. He has invested 21K into the business at startup which was financially and some equipment. Take his draws out and the company is profitable. Subtract his investment from his draws, and remove the remainder and the company is still profitable.

Thanks again,

Terry D.

[JohnH]

Oh the excitement.

Just think, if it turns out his company isn't an S-corp and you can't qualify him under an exception, you get to explain the concept of "constructive dividend" to him.

[kcjenkins]

Well, I'd certainly take the first draws as repayments of his contributions, then your salary gets into a more reasonable area. Also, I would not take any salary that put him into a loss. And if you can get the salary into the current quarter, that would be great. But it's what it is, so you are right to tell him that's the way it has to be treated. No need to make his problem into your problem.

[lbbwest]

"However, that loss is due to the shareholder deducting his "draws". He now shows that he withdrew 56,900 w/o any payroll taxes"

I am very confused (brain damage due to lifestyle choices)

How does one deduct "draws"?

So, are you saying that one should take a draw throughout the year to live on, then maintain that it is a return of capital?

Perhaps the Appeals officer that stated the IRS "likes" to have 50% of net income of S Corps as draws, hasn't read the same Tax Court cases that the rest of us have. lbb

[joelgilb]

Hmmm think you misunderstood both comments.

First, there were several Appeals officers at the seminar and they ALL agreed that IRS is accepting the position that S-Corp shareholders can reduce their wages and shift money to draws! Note that technically you should have a defensible position for the lower salary.

Further as an attorney I have fought this battle and won every time, so long as the client had a salary that made some sense. Now it is for you to use your judgement as to what makes sense! Also, exposure for audit and adjustment on this is is drastically reduce if there is some reasonable level of salary. This shifts the burden of proof to IRS to prove that the salary is too low.

Burden of Proof is a tough thing. If O.J. Simpson had the burden to prove he was innocent of murder, he would have gone to jail for the murders.

As for the draw as an expense issue, don't most of clients misunderstand income and expense vs balance sheet items. This is a common thing that we have to correct in our clients QuickBooks files, especially for new small business owners. They have a hard time understanding the concept of a "Draw".

[Terry D EA]

You are correct with the client's confusing expenses with the balance sheet items. This is the case here. My statement may have been confusing. I have not adjusted any books, created an adjusted balance sheet; etc, and my client shows a loss within his company by deducting the total of the "draws" he took as an expense. I know this is not the way it is done at all.

I have come up with the following plan:

1. This whole thing is based on the information regarding the filing of form 2553 and the IRS records regarding the S-Corp status and tax payer year. I agree the client's idea this is a fiscal year really throws me off as well.

2. If my client misunderstood the S-Corp filing year, I plan of telling him we will file the return as a calender year tax payer which will probably eliminate any taxes he may have to pay. How? He started this company in July of 2007 and only shows two quarters of income and expenses which will result in a pretty good loss. His draws will be against his investments in the company and will leave him a small balance in the capital account. This way, no employment tax penalties, no employment tax dues with the only remaining possible penalty is failure to timely file. He will face this with the state as well.

Thanks for all who replied. If KC or Old Jack can site a source for the items you mentioned earlier in this thread, I would appreciate it.

Thanks,

Terry D.

[joelgilb]

Terry:

And if your client has actually not filed the 2553 but has not yet filed any corporate tax returns you can still fix his S-corp election. Make sure before any returns are filed that he is an S-Corp. If not IRS has simplified the methods of correcting failed S-Corp elections (see form and instructions) once again.