S corp distribution issues

[drc34718]

Question of interest: I think I know how to answer thsi one, but wanted to get some suggestions:

I was called by a potential client about S corp issue: Don't have all the specifics as of yet, but in general.

T/P is sole shareholder is S Corp. Was using a payroll service through 2003. Obtained a new accountant at that time and the new accountant told T/P that as an s shareholder, did nto have to pay salary on monies coming out as they could be taken as a distribution. Accountant did not mention that the distributions per se should be coded as loans to S/H. Therefore, for last three years, T/P has been taken distributions from S corp and treating them as an expense of S corp without payroll considerations. Accountant has prepared returns for last three years with this activity present. Apparently, a comment made to the T/P led him to question this activity at end of 2007, and subsequent conversations have led the T/P to the understanding that there is a big problem here.

As I see it, we have monies coming out that should have been treated as loans to S/H (and could have been recharacterized as taxable income at end of each year and payroll taxes paid accordingly) but did not happen..S corp income is understated, 1040 income is understated ( or I won't say understated, but rather the character of the income is incorrect leading to potential taxing issues)..and it needs to be fixed..

I am thinking going back to respective years, determine the payroll implications, amending the 1120S and 1040, paying proper payroll amounts in and then the penalties/interest on top of that needs to be considered. As to any legal implications of what happened, I will leave that to T/P's lawyer.

My question is have any forum members run across such a situation and if so, best way to deal with it?

Thanks in advance..

Dale Cooper

[Bees Knees]

I would inform the client about the rules and the risk of having to pay extra if audited. I would tell the client the previous tax preparer should fix the problem for free, if the client wants all previous years fixed. But I would not suggest that I can fix the problem for a fee.

The reason is payroll for S corporations is a facts and circumstances thing. There is no black and white answer as to what exactly should have been paid as wages verses distributions. Therefore, if you charge the client to fix something that may not be as broken as you think it is, you are imposing your opinion on how you think the results of an audit will be.

How do you know the exact amount of payroll verses distributions an auditor will accept? Some auditors will ignore all past sins if the taxpayer agrees to follow payroll rules from this point on. So you could be causing your client to pay all kinds of penalties for nothing.

I would say I will prepare everything properly from this point on, but if he wants to change the past, he needs to have the previous accountant do that.

[Bees Knees]

I know this is for the independent contractor verses employee issue, but I think there are similar principals here that you need to consider. TTB, page 5-22 says:

Section 3509 Relief
If an employer fails to treat a worker as an employee, and the failure
was not an intentional disregard for the rules, the employer
may qualify for a reduced tax liability of the amounts that should
have been withheld. The employer can treat 1.5% of wages as the
amount that should have been withheld for federal income tax
withholding, and 20% of the Social Security tax as the amount
that should have been withheld. Penalties and interest may still
apply. There is no relief for the employer’s share of FICA or FUTA.
[IRC §3509(a)]

Even if the employer does not qualify for Section 3509 relief, the
employer may be relieved from paying some of the tax that should
have been withheld by filing Form 4670, Request of Relief from Payment
of Income Tax Withholding, along with Form 4669, Statement of
Payments Received, that shows the employee reported the income
on their federal income tax return and paid the federal income
tax due.

The point is, there are relief procedures for various rules concerning payroll that can lesson the impact of simply going back and treating everything as payroll, and paying all penalties associated with it. If the client cannot get the previous accountant to fix the problem, and really wants you to go back and fix it, you need to study up on all of the possible relief procedures that could lesson the penalties for failing to file and report payroll.

[outwest]

This is why I read this even in tax season..

Bees I've got a employment tax audit report that I was taking to appeals where this is right on point. One more argument to help the taxpayer.

I'll post the whole situation one day this summer, it's unique situation involving "payment in kind" issues, third parties, and promoters on the run.

[drc34718]

thanks

Bees,

Thanks for the advice..You have a very good point in that wages/distributions is subjective..If client wants, we can look at worse case assuming all is wages and then adjust form there..as to the prior accountatn doing work, I'll have to see what the realtionship is between them..

Regardless, I appreciate your comments and will discuss with the client tomorrow.

Thanks again..

Dale Cooper