What a Doozy!

[j2kp0t]

Taxpayer owns an S-Corp, which netted $115K in 2004. Taxpayer’s 1120S shows no reasonable compensation paid to him and his spouse, both officers of the corporation. So the two K-1s flow the entire $115K down to the Sch E on their personal return.

Taxpayer operated a 401K plan for the employees of the corporation and deposited $7500 apiece, total $15000, in his and his spouse’s names.

What to do? Withdraw the $15000, and pay penalties on the 2006/2007 return? Or issue W-2s for reasonable compensation (and reflect the contributions), then amend the W-3s, quarterly and annual payroll tax returns, as well as the 1120S? Or is their another option we’ve overlooked?

[BOB W]

All I can..............

.............tell you is to do one or the other. BUT, if it was my choice, I would add payroll because of other issues related to reasonable compensation. This is another reason that I only handle clients where I'm envolved on a monthly basis.

[OldJack]

Since you are talking about a K1 for 2004 (that must have already been filed with the IRS) you must not have prepared the tax returns. Therefore, its not your problem other than maybe to point it out to the client and I would question you doing that. Maybe the best thing to do is let a dead dog lie.

[BOB W]

Old Jack,.......

..... you are probably right. I didn't see that it was a 2004 return, but it still leaves the contribution in excess. The administrator of the 401k has also made a huge error by not verifying gross payroll.

[Bees Knees]

If the client was audited, the 401(k) contributions would be treated as contributions to a non-qualified plan. Therefore, the deduction that flowed through the S corp to the shareholders would be dissallowed, increasing taxable income on Schedule E by $15,000.

Amending the 2004 Form 1040 for $15,000 of unreported income will cost the client far less in penalties than making a federal case out of the payroll tax issue, along with payroll tax penalties and interest.

[BOB W]

I'm confused again......

Isn't a 401k a payroll deduction/contribution? I submit that the $15,000 was not deducted anywhere, just a contribution made to the plan.

[outwest]

Hmm I wonder if the bigger issue is...

the possible disqualification of the 401k plan. Runs in my mind the excise taxes on the disqualified pension plan and making ALL (not just the owners) plan participants having to pick up not only the contributions plus earnings plus plan penalties and interest might be a bigger issue. Especially 5 years down the road. When it come to 401k plans I think it's better to fix than let it ride.

If the client was audited, the 401(k) contributions would be treated as contributions to a non-qualified plan. Therefore, the deduction that flowed through the S corp to the shareholders would be dissallowed, increasing taxable income on Schedule E by $15,000.

Amending the 2004 Form 1040 for $15,000 of unreported income will cost the client far less in penalties than making a federal case out of the payroll tax issue, along with payroll tax penalties and interest.

[Bees Knees]

That is why you take the money out now and treat it as a mistake. Make the owners amend their personal 1040 for the extra $15,000 of income since they weren't allowed the benefit of the 401(k) contribution. The plan could be disqualified for all participants if the IRS discovers the error first.

[BOB W]

j2kpOt and Bees....

Can you verify that the $15,000 was ever claimed as a deduction. I think it was just deposited in the 401k account...?????

If it was deducted, where and how?????

[j2kp0t]

It was not, as far as we can tell, deducted at all.

[BOB W]

I thought so...........

.........., so the money needs to be withdrawn. Now what will happen when the money is withdrawn and what steps need to be accomplished to ward off a 1099R under a non deducted contribution??????

[BOB W]

Maybe.....

a second thought should be considered in issuing a W-2 for the year 2004. The net results should cause a refund on the 1040, probably greater than the 941 penalties.

[Bees Knees]

It was not, as far as we can tell, deducted at all.

So are you saying the S corporation showed the contribution as a nondeductible expense for the shareholders on line 16c of Schedule K? Or did it treat it as shareholder distributions on line 16d of Schedule K?

[j2kp0t]

I'm saying its not on the S-Corps return at all. The client brought it up, somehow under the impression that they could deduct it on their personal return.

[Bees Knees]

Then I would suggest looking for where the money came from. Maybe the S corporation DID deduct it along with all the rest of the 401(k) contributions from the employees. The trustee of the 401(k) would have required the funds to be paid through the business. A 401(k) plan cannot accept contributions from individuals.