S-Corp reasonable Comp

[HOPE2]

Hi. My new client has taken distribution but did not pay himself reasonable comp as of Jan first till now. I send him IRS's procedures for compensating for shareholder-employees and officer.... We figured his salary out( two days ago) and next week would be his first payroll. My question is: can we run payroll for July first till Sep 30th for missed period before Sep 30th? I mean for third quarter. In general, if a client has taken distribution but did not have payroll for some part of the year(quarteres1 & 2) what we can do for him? Is there any reclassification to reverse taken distributions to payroll tax. As we know, Client missed some part of the year for payroll.

Any comment would be appreciated.

[Jim-from-Ohio]

If it was me faced with this I would

1. Run a third quarter payroll

2. I would not date any official payroll checks for earlier quarters.. all returns would be late at this point and face penalties

3. As far as making a journal entry for QTRs one and two S Corp distributions aleady taken. how much are they?  if minimal I would leave them as S Corp distributions.  If subsantial you can do a deduction on your 3RD quarter paryoll. in essence credting S Corp Distribution as part of your payroll entry.

[qbteachmt]

Good for you for catching it before year end!

Here's how I teach payroll and S Corps:

You can take one annual paycheck, or quarterly or monthly or whatever, and still be in compliance. But I recommend not taking distributions as often as payroll or in lieu of payroll.

Here's how I would work through it:

The point here is paycheck date is never backdated now (since you are in the same calendar year), because as was pointed out, that makes everything late. For end of Sept, pay the wages that are for Jan-Sep. Date it for the end of Sept, because that is the reality.

Here's what the paycheck should show:

Everything taken as distribution turns into Loan to Shareholder (asset) to be recovered in this first and subsequent paychecks by net pay (out of takehome, not affecting taxes) deduction. That might mean "grossing up" the amount, because there should have been tax deductions and withholdings, and the company needs to be able to afford to pay its share of taxes, too. So, it's going to depend on how financially healthy is that bank account. Don't end at less than $0, of course, for the takehome amount.

You can even do this over the course of the remaining paychecks in the year. Example:

I took $12,000 already. I would like my paycheck to be $1,000 a month, so I'd like to be paid for Jan to Sept as $9,000 now, but after deductions, that might only be $7,500 takehome, and I need at least $500 takehome as funds. That means this first paycheck, the end of Sept, is grossed up so taxes compute and I am left with $7,500 and then we deduct $7,000 against my shareholder loan.

Now I still owe $5,000.

At the end of the year, whatever is left of Shareholder Loan can be considered distribution or still to be repaid in the next year, depending on how you view the data against Reasonable Compensation.

If you just ignore the distributions and move on to Payroll, you run the risk that payroll looks unreasonable next to the amounts already taken, which really should have been taxed through payroll for the most part, anyway. Again, it depends on the financial health of the business and perspective. I had a client who would take "loans" through the year, because her contracts didn't settle until the fourth quarter (her business was Summer seasonal), and then we would do an annual year end paycheck (including fringe benefits like personal use of company vehicle). Her distributions were 1/10th of her final payroll, but she claimed she was never sure through the year how the year would end, so she handled her uncertainty with minor cash distributions, then a big paycheck at the end.

[TaxGuyBill]

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@HOPE2 wrote:

Hi. My new client has taken distribution but did not pay himself reasonable comp

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I know many people argue with me when I say this, but ...

Did your client say that money was a "distribution" (an owner's benefit, taking profit from the company), rather than "compensation" (being paid for the work performed for the company)?

Not filing payroll forms does NOT necessarily mean they did not take compensation (payment for the work performed).  It very well just mean that the payroll forms are late.

[HOPE2]

 If subsantial you can do a deduction on your 3RD quarter payroll. ( You mean deduction for what? Payroll or distribution) He did not have payroll as of Jan till now but taken continuously distribution around $95000. We have to increase payroll? right?

-in essence credting S Corp Distribution as part of your payroll entry. ( I need a little more explanation)

Thank but did not understand could please explain it more.

[Jim-from-Ohio]

This is what I would do.. i know some may handle it differnetly.   First establish reasonable compensation for the year.. say for example.. $ 125,000.. that is maybe about the amount of gross wages to clear the amount already taken, $95,000.  With a september date I would in my payroll program run a gross check for $ 125,000, deduct $ 95,000 as credit to S Corp Distributions, and take out the rest of the available check so the net check then is zero.  

For the rest of the year now.. if $ 125,000 was a reasonable compensation you could treat the remaining funds that they need personally as S Corp distributions or if the owner wants to pay more into Social Security/or if $ 125,000 is too low for reasonable test they can run more payroll in quarter 4. 

[qbteachmt]

"We have to increase payroll? right?"

You have to create the first paycheck. There is nothing to increase.

I somewhat disagree with Jim for how to handle the rest of the year, since it is not year end already. I don't support more taking (3 remaining months) unless it is through payroll (or at least some of it), because technically, there should be ongoing payroll if there is ongoing taking.

Waiting to take a year end distribution would get around that perception (as long as it doesn't appear to be a bonus that should have run through payroll), so I would counsel the client not to take more until year end, if we are not also making paychecks and if we want to establish (in his example) $125k as the yearly salary.

On the bright side, you can set $125k as your reasonable compensation, and take twice that in a good year, through payroll, without having any issue that starting in 2024, you are going back to using a base salary of $125k. In other words, perhaps 2023 will be "base" of $125k + $95k as "grossed up" bonus to be able to repay that Shareholder Loan.

It just depends on the financial resources, because all of this is going to result in both the employee and the employer paying payroll taxes. And if he established a wage-related retirement plan or other benefit package, that needs to be factored into all of this.

Another "on the bright side" consideration: if he has been paying estimates, you can set his Fed Income Tax withholding to $0 for 2023 and change the W4 for 2024.

[HOPE2]

Thanks thanks for helping me you all. as you know loan more than $10,000 and must have promissory not and IRS interest rate so do we have consideration part of interest when we balance the loan with payroll? right?

Problem is company has no enough fund to run this large payroll. What would it be the next?

[qbteachmt]

"as you know loan more than $10,000"

You are working in the same calendar year, though. Can they pay it back by year end? If not, take the remaining balance as distribution. It's different when it's after year end, or even a running balance for loan to shareholder. But I don't recommend they leave $95,000 as distribution now and decide $125,000 is reasonable salary, and only pay the last quarter of that as payroll ($31,250) because that is 1/4 compensation and 3/4 distribution, and that is a bad ratio.

"Problem is company has no enough fund to run this large payroll. What would it be the next?"

Exactly why I brought up banking and taxes.

First, the minimal amount of Net Takehome paychecks for 2023 can end at $0 takehome after deducting taxes and what was already taken. And you might need to break it into chunks, working towards year end.

Here's an example:

He already took $95,000, but let's do our first paycheck as $30,000 gross. Their bank account does not have to cover $30,000; that's already been paid out. It has to cover (at a minimum in this example) what should have been the employee SS and Medicare taxes and the employer's taxes (SS, Medicare, Fed UI, and perhaps State UI). Let's pretend that comes to around $2,300. You would issue a paycheck that is:

$30,000 gross pay

$2,300 is owed by the employer for Employee taxes (to be paid out)

$27,700 net pay deduction towards repaying the shareholder loan (earlier distribution)

= $0 takehome.

Now the distributions are:

$95,000

- $27,700

= $67,300

Now you have a paycheck for no new money, and you have employer taxes owed:

$2,300 (same as employee for SS and Medicare)

$420 FUTA

= $2,720 (employer)

+$2,300 (employee)

= $5,020 <== company owes this from bank to pay payroll taxes owed on first paycheck (example)

That's the only new money that has to leave the bank.

And from now on, FUTA is done.

Not knowing his filing status, etc, and eliminating income tax withholding (assuming that's something he was taking care of already, and let that ride for 2023), a $30,000 paycheck Sept, Oct, Nov, Dec is pretty much the example base pay. It's the takehome that needs to be reduced, until the (earlier) distribution are mostly or totally offset.

This turns distribution into shareholder loan over a year end, if you want to let it ride (if it is under your $10,000 limit). Or, it turns shareholder loan at year end into distribution for the remainder that wasn't repaid through payroll Net pay deduction.

It's all just strategies. It's all just math.

(Let me know if you check my math and I got something wrong)

[TaxGuyBill]

Maybe its because I don't come from an accounting background, but I don't "cook the books" by creating non-existent loans to make things look better.

First, explain the requirement for "compensation" and inform your client that late penalties and interest apply to any late payroll forms if he took any taxable "compensation" before July.

Then for each time your client withdrew money from the corporation for his personal use, ASK him what it was for.  Ask him how much of that amount was (a) compensation for the work he performed for the corporation, (b) taking an owner's benefit/payment from the corporation's profit for non-work as an owner (which is a distribution), or (c) a loan to himself.

Then file accordingly.

[BobKamman]

"I send him IRS's procedures for compensating for shareholder-employees and officer

IRS doesn't have any procedures for that. 

"We figured his salary out( two days ago)"

What qualifies you to figure out what his reasonable compensation could be?

"and next week would be his first payroll."

But of course, next week is a new calendar quarter.  Does he have other employees?  Are you already filing quarterly employment tax returns?  Is this a business where income fluctuates greatly from year to year (for example, retail gift shop or federal government contractor), where you don't even know until December if there will be a profit?  How long has he been doing business as an S corp?  As @qbteachmt states, you can make payroll an annual payment, and in some cases that might be a good idea.  In others, not so much.  

[Accountant-Man]

I used to have a client who only took payroll in December. That's when he told me how much money was in the bank and how much he needed to keep on hand.

I then backed into wages, payroll taxes for the S corp., and his SEP as well. After a few iterations I made the payroll calcs, paid the taxes and filed the forms.

[Jim-from-Ohio]

under the example i gave, you do not need $ 125,000 plus the company side of taxes but would need the total calculated as follows

$ 125,0000 

+ Company side of taxes

less  $ 95,000, as this amount was alread paid

[HOPE2]

Thanks a lot you are very helpful, it was my fault that did not explain the years separately since I am dumb to understand maybe so sorry.

Let me clarify: for 2023 

RC is $125000 and no payroll till now, has taken $95000 as distribution could you please if give me numbers and how to run payroll for the rest of the year really appreciated as you mentioned 3/4 and 1/4 regarding the money taken and payroll will be done.

Also, his wife who has 51% interest shareholder and has a few hours in a week her RC is $25000 but did not run payroll as well.

How do I determine percent devoted in S-Corp for her and him, can I prorate by RC like this 25000/(25000+125000) would be 16% is it fine?

 For 2022 :: ( due date Oct 16, 2023) he has not W-2 but his wife has for $25000. Has taken $121000 distribution till now.

How about percentage devoted on 1125-E?

As I understood the whole amount for distribution convert to loan to shareholder and calculate interest receivable for each distribution in 2022 that I even do not know when he wants to payoff the loan in 2023! for calculating the interest to be honest. I am sure he taken as often as money as distribution when he needed. Is it a good idea having a 1099 for compensate of the payroll tax? but sure will get a penalty.

I had a client who would take "loans" through the year, because her contracts didn't settle until the fourth quarter (her business was Summer seasonal), and then we would do an annual year end paycheck (including fringe benefits like personal use of company vehicle). Her distributions were 1/10th of her final payroll, but she claimed she was never sure through the year how the year would end, so she handled her uncertainty with minor cash distributions, then a big paycheck at the end.

For above topic you meant only one payroll in the year but she taken loan during the year instead of distributing in her accounting right?

[TaxGuyBill]

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@HOPE2 wrote:

has taken $95000 as distribution

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Has he specifically told you that those were distributions (an owner's "cut" of the profits)?  That none of that was to pay him for the 'work' he performed for the business?

Just because payroll forms were not filed, does NOT mean it is not payroll/compensation.  You can't arbitrarily call it "distributions" unless that is what the client told you it was for.  You need to ASK the client.  If any of it was to pay/compensate him for the work he performed, you should be filing late payroll forms.

[abctax55]

"Problem is company has no enough fund to run this large payroll. What would it be the next?"

Well, that is because s/he has *already* taken the net cash out as a distribution.  When it *should* have been taken as net paycheck(s).