1099 NEC can it be used to pay and S-Corp owner as salary at year end

[jadira1021]

Hello everyone, 

I have an S-corporation customer, and both husband and wife run a trucking business.  They have filed their 1120S forms with the IRS.  They were issued a K1 and 1099NEC (weekly salary payments ).  I would like to know if the issuance of the 1099-NEC for purposes of paying themselves is correct.

[dkh]

I would like to know if the issuance of the 1099-NEC for purposes of paying themselves is correct.

No.

[dkh]

Just out of curiosity......Did this client prepare their own 1120S return but want you to complete their 1040 return?   

[jadira1021]

Hi, 

This is what I thought after reading on this topic but I was confused as an article I read stated that a shareholder-employee can choose to receive a salary as either an independent contractor or an employee.  Another article mentioned that an S-corp offers business owners three basic options for paying themselves: by salary, distributions, or both. But that the right choice depends largely on how the owners contribute to the company and the company's finances.  I also read that owners of S-corps who have a hand in daily operations fill two roles: one as a shareholder and another as an employee.  However, owners who do not oversee daily operations are classified only as shareholders, and the role an owner plays in their company directly affects how they get paid under the S-corp structure. 

I did not prepare the 1120-S tax form the customer used their tax accountant.  They wanted me to prepare their personal taxes claiming K1 and 1099-C, and the 1099-NEC (salary they got paid).    

[jadira1021]

Their tax accountant prepared their 1120S. 

[jadira1021]

Yes, they want me to prepare their personal tax return portion. 

[jadira1021]

Can you provide me with guidance as to what should the customer do with this scenario?  Thank you!

[dkh]

https://www.irs.gov/pub/irs-news/fs-08-25.pdf

https://www.irs.gov/businesses/small-businesses-self-employed/s-corporation-compensation-and-medical...

If it were me, I send the customer back to the tax accountant to have their 1040 return completed.

[jadira1021]

Thank you for all your input on my question.

[dkh]

You're welcome.

[qbteachmt]

"Another article mentioned that an S-corp offers business owners three basic options for paying themselves: by salary, distributions, or both"

Where you read this must have been ancient. First, a non-working shareholder and a shareholder-employee get K1 from the entity. You never get a 1099-NEC from your own entity. The working shareholder is an employee and gets Reasonable Compensation for work performed as Payroll. The IRS is cracking down on that. You are not a contractor to your own entity. There is no draw, nor distribution in lieu of payroll. 

[IRonMaN]

I hope they never get audited and you are forced to defend their position.  Your comment of “(weekly salary payments)” would make it one of the shortest audits on record😉

[BobKamman]

"Another article mentioned that an S-corp offers business owners three basic options for paying themselves: by salary, distributions, or both"

That's true.  But there has to be some salary, commensurate with what they would be paid in an arm's-length transaction.  Obviously, if they collect more than that, it must be from their investment in the company and that's what shows up on the K-1.  

IRS isn't cracking down on this any more than they have for the last thirty years, and of course since the recent movement to defund the tax police they aren't cracking down on much these days. It's acceptable to use the 1099  for some things that would be reported that way anyway, such as director's fees.  And they might argue that they come under allowable practice for truckers, since many of them are paid with a 1099 rather than a W-2.  The fact that they're doing the 1099 shows some awareness that they have to pay Social Security taxes on some of what they earn.  Did the 1120-S show it as shareholder compensation?  That might make a difference, or it might not, depending on whether IRS is matching payroll returns to income tax returns, or just looking at that line entry.  

Was this the first year the 1120-S preparer did that return?  They might have been told they could do it that way for 2021, but don't come back and get someone else to do the 1040.  

[jadira1021]

Hi, 

I was able to check the articles of incorporation, the husband and wife are both registered on the form.  Form 1120S does not show any type of compensation for shareholders nor for line 7 for Compensation for Directors.  I do see that under "Other Deductions" there is an expense for  "Contracted services and independent contractor expenses".  I am very confused as to other people said that they are considered employees because they are owners and work for the company thus needed to have been paid with payroll and given a W2.

[jadira1021]

Yes, this is the first year they filed a 1120S form.

[IRonMaN]

"I am very confused as to other people said that they are considered employees because they are owners and work for the company thus needed to have been paid with payroll and given a W2."

The golden rule of S corps - thou shall take a reasonable salary.  If they own the business, kinda hard to be an independent contractor.

[qbteachmt]

I use rcreports.com who had an online session today, to help you understand Reasonable Compensation per IRS regulations. They include legal case law perspective. Your client formed an S Corp for a reason. They should be in compliance with the requirements. 

[BobKamman]

Now that "what shoulda been done" has been covered, let's get back to "what to do now."  The whole purpose of requiring S corps to pay owners for their work is to prevent evasion of Social Security taxes.  If the amount on the 1099-NEC is reasonable and reported on a Schedule SE, IRS has nothing to complain about.  They might not have found out about what they should have done in 2020, until 2021.  At that point, someone made the decision to avoid penalties on late-filed 941's by using the 1099-NEC instead.  Considering the IRS backlog of unprocessed 941's, that may have been doing the government a favor.  

What they should do now -- what they should have started doing already -- is report wages on payroll tax returns.  That includes state reporting requirements; they're also evading unemployment taxes.  Meanwhile, get the 1040 filed.  Unless you're in a disaster area, you're already late. 

Speaking of RCReports, here is their take on the issue, which admits that sometimes an S Corp can 1099 an owner:

https://rcreports.com/resources/reasonable-compensation-blog/1099-or-w-2-for-shareholder-employees-o...

The example they give is real estate agents.  But as I noted earlier, there might be a case where an OTR truckdriver can claim the special status.  That's a big issue these days in the "employee vs. IC" debate in California, for example.  

[IRonMaN]

"If the amount on the 1099-NEC is reasonable and reported on a Schedule SE, IRS has nothing to complain about."

They don't care about federal unemployment taxes or about getting that money faster than they would if a payroll check was being issued?  I guess the IRS is getting to be a much kinder, gentler organization.  What about the state?  They aren't interested in collecting some additional unemployment taxes?  You would think they could use a few extra bucks after that little COVID deal.

[BobKamman]

Did I say the state had nothing to complain about?  My state starts new employers out at a 2.7% rate on the first $7,000, so the amount involved here for two people is less than $400.  If they ask for it, then pay it.  The point is that it's not going to get any better by filing 2021 quarterlies in late 2022.  

The power went out at my office yesterday afternoon -- maybe showing solidarity for Ukraine -- so I went and got a haircut.  My friend, client and barber told me about the 87,000 armed IRS agents that are on their way if the socialists get re-elected.  Since IRS relies on fear as the pillar of its compliance program, the increased budget may already be serving its purpose.  But the truth is out there:

"In the past, the IRS audit rate for partnerships and S corporations has been very low—around 0.05% (or one out of every 200 returns). This audit rate is one-half the rate for individuals and one-quarter the audit rate for C corporations. In addition, about 50% of all partnership and S corporation audits in the past resulted in no changes to the tax return."

https://www.hsdtaxlaw.com/irs-audits-of-partnerships-and-s-corporations-are-coming-are-you-ready#:~:....

In the unlikely event of an audit, what they owe isn't going to be any worse than if they try to put the toothpaste back in the tube today.  What's important, even IRS will admit, is to get them into compliance for 2022 and future years.  

[qbteachmt]

"which admits that sometimes an S Corp can 1099 an owner"

The article states no such thing. Not "can" 1099, but should be using W2. 

[BobKamman]

I had several websites open and I copied the wrong URL.  Here's the right one, from your favorite rcreports.com:

 https://rcreports.com/resources/reasonable-compensation-blog/1099-or-w-2-for-shareholder-employees-o... 

"What about real estate agents? Of course, they are independent contractors!

Jack says: Sometimes.

It is a fact that real estate agents can be paid via a 1099 for the work they do as a real estate agent. An agent paid for doing tasks other than selling real estate must have wages for those tasks reported on a W-2. There are two options here:

1. 1. Issue a 1099 for real estate services and issue a W-2 for all other services, or
   2. Put all compensation on a W-2.

Since it would be more efficient to put everything on a W-2, put all compensation on the W-2."

[wmmosley]

You are so right the owner must be on payroll paying themselves a reasonable salary.  A reasonable salary has not been defined by the IRS, but you must use common sense. you can't make 600,00 and pay yourself 200.00 a week, that unreal.  Also a owner can also make a distribution but cannot go over the amount they pay themselves.  Please correct me if I'm wrong that was my interpretation in my research.

[TaxGuyBill]

---

@wmmosley wrote:

you can't make 600,00 and pay yourself 200.00 a week, that unreal. 

Also a owner can also make a distribution but cannot go over the amount they pay themselves. 

---

No, the reasonable compensation is based on the work performed.  If an owner has a manager that does all of the work and the only thing the owner does is call the manager once a month and file the tax return, $200 a week may be fine (or maybe even too high).  But if the owner does all of the work, you are right, the compensation needs to be reasonable for the amount of work performed.

Distributions are not directly related to compensation.  In my example above, if the owner does almost no work, the salary would be very low and the distributions could be very high.   But if the owner does all of the work, the majority of the profit would be salary/compensation.

[BobKamman]

The more you dig into this, the more you realize that it comes down to “any given auditor on any given day.” It’s all about “facts and circumstances,” with some “what can I get away with” thrown in.

What if reasonable compensation for an owner is $60,000, but because of unforeseen events, the business didn’t make any money and actually shows a $40,000 loss before any wages are paid? Is the owner still required to collect the salary, then show a $100,000 loss on the Schedule K-1?

What if the profit before payroll is $100,000 but there were no distributions because the owner chose to invest in business real estate or equipment? Is IRS going to require a $60,000 loan because wages come before investment?

My guess is that many of these questions about S Corporation salary are from preparers whose clients were advised by someone else, on what business entity to choose. That adviser may have a good idea of what will pass muster, given that historically, S Corp owners have been audited at the low rate of 0.05 percent. $30,000 may be at the low end of “reasonable compensation” when $70,000 in distributions were also paid. But when thousands more corporations paid nothing in wages, where does IRS start? Not that I’m saying that should be a factor.

[cnd10]

They should be receiving W-2; they are considerted emplyees.

[qbteachmt]

"Also a owner can also make a distribution but cannot go over the amount they pay themselves. Please correct me if I'm wrong that was my interpretation in my research."

It's a reasonableness check. It isn't reasonable to take twice your salary, bypassing payroll for the other half. It is reasonable to be paid for services, and a good test for reasonableness is the replacement cost for that same work if not being done by a shareholder-employee. And it is reasonable to pay yourself a good rate and end up with such profitability that you can take a huge distribution, as a sole shareholder, and if there were other shareholders, everyone would get a cut, even the mother-in-law that is a shareholder but does no work for the corporation and therefor is not on payroll.

"the business didn’t make any money and actually shows a $40,000 loss before any wages are paid?"

The additional piece of info is, were any funds taken by the shareholder, anyway? Because, yes, you can have payroll and also show a loss, as from loan proceeds or sales of assets. Just don't sell an unused forktruck and take that money home as distribution.

"are from preparers whose clients were advised by someone else"

And we have seen some really bad guidance. Look at how often people ask about selling their primary residence and "reinvesting the proceeds" to avoid reporting gain. That hasn't even existed for one generation of adults, at this point.

Those are just example scenarios. You would want to be able to defend your position. It's not that different from when the speed limit on our highways was "reasonable and prudent." We have great stories from people who were stopped, and didn't get ticketed.