Form 1120-S IRS Audit

 The IRS will tax shareholder distributions as other income on Form 1040.

Are you sure?  Does the shareholder have any basis?  Why didnt they run payroll for themselves as required?

Are you sure they aren't coming after the corporation next?  Reclassifying the amounts as payroll on the corporate side would generate some nice income for the IRS when they can go back and clip them for late payment of payroll taxes plus a little interest, just to sweeten the deal.

Let's not get hurt jumping to conclusions.  Why do you assume the taxpayer does any work for the company?  What if he is only an investor?   Is there some law that all 1120-S owners must work for the company?  What if this is a dispute over whether money he received is a loan repayment, or a dividend?

This was your heading "Form 1120-S IRS Audit"

I haven't had any audits, S Corp or otherwise, in a while but it seems to me the IRS would audit the S Corp first and then make the corresponding adjustments to the shareholder(s)' returns. If that's what they did, get a copy of the Audit Report for the S Corp. The net income has probably been reduced.

I'll tackle this a bit:

"If the taxpayer has to report the distributions as other income, does this mean the business entity can reclassify the distributions as other expenses"

Why would it be expense? What did it pay for? Isn't it just money out? Distributions are like "owner draw" and it's not an expense. It's from Equity. That's why you were asked: Does the shareholder have any basis?

Think of the condition where there is no income and no basis and the person still took a distribution. For example, the company is broke, they can't even make payroll, so your shareholder gets a loan and takes it out to use personally. That's either owed back to the corporation (loan to shareholder) or has drawn their equity to negative. All of this is balance sheet, not expense.

As to reporting distributions as other income, go back to the K-1 reporting. Think about how the income of the entity is reported on the K-1, whether or not it is Taken Out of the entity. You would not also get to report the taking, much less as expense to the S corporation or as other income to the shareholder, when it's already reported properly on the K-1. Don't confuse S Corp, C Corp and Multi-member LLC activities.

The IRS can reclassify tax-free distributions as wages, triggering back payroll taxes, penalties of up to 100% of the unpaid tax, and interest.

Shareholders must receive a "reasonable salary" (comparable to market rates for services provided) before taking distributions. This has been a hot topic for decades.

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