This time of the year, tax accountants confront a common problem. That problem?
Well, okay, this is awkward… but somehow, no one quite knows how, the S corporation hasn’t paid enough payroll to the shareholder-employee.
Maybe the first quarter, the firm lacked cash. Second quarter, things got really busy. Then, you know, summer.
And now, with just a few weeks to go for the year, the S corporation hasn’t paid some shareholder-employee enough payroll. And very possibly the firm doesn’t have adequate cash flow to load enough payroll into the last quarter.
This predicament is a serious problem. As you know if you’re reading this, the IRS requires S corporations pay shareholders a reasonable wage. So what can someone in this situation do? Here are some ideas.
Tip #1: Size the Problem and Assess the Severity of the Problem
A first tip, perhaps obvious. Before you get too worried, size up the problem and assess the severity of the payroll bungle.
Regarding the size, come up with a number that you need to “make” to meet the IRS requirement of reasonableness.
In other words, maybe you always planned to pay some shareholder $80,000. But is $60,000 actually “enough?” And have you in earlier quarters or year-to-date payrolls already paid some of this?
For example, does $60,000 “work” and have you already paid $30,000? And so is the problem actually a potential $30,000 shortfall? You want to know this number.
A related factor to consider. The IRS, if you shortchange them on the payroll taxes and they spot it, re-categorizes distributions or other shareholder payments as payroll. That’s the risk you face if you don’t do enough payroll.
Accordingly, say you quite honestly do need another $30,000 of payroll to achieve “reasonable compensation.”
If you’ve paid zero distributions, true, you should pay an additional $30,000 of wages. But your risk if you don’t pay the additional wages is essentially zero. The IRS needs distributions or similar payments it can recategorize to force you after the fact to pay payroll and to levy penalties.
Tip #2: Re-categorize a Previous Quarter’s Distributions
But say you find yourself short. And need to, before year end, bump up your wages. A first thing to look at: Can you reclassify shareholder distributions made in a previous quarter as wages?
For example, say you paid out generous distributions in the third quarter. What you might do is belatedly treat $16,000 of these payments as payroll to the shareholder-employee.
If you’re running a small S corporation with just a single shareholder who also happens to be the sole employee, you may be able to file a 941 for a previous quarter that shows no federal taxes withheld and $2,448 of Social Security and Medicare taxes owed. You can file this 941 and pay the $2448 tax deposit with the form.
The tax deposit will be late. So, you’ll get hit with penalties and interest. But if your 941 return was due Oct 31 and it’s only a few days past that date? You may not be that late.
Tip #3: Handle any Shareholder-employee Health Insurance Correctly
A quick idea: Be sure you “do” the bookkeeping correctly for any shareholder-employee health insurance.
An S corporation shareholder-employee with, say, $10,000 of annual health insurance should treat the health insurance as wages subject to income taxes. Note that these “faux” wages aren’t subject to payroll taxes like Social Security and Medicare. As a result, they don’t really help you create more reasonable compensation. But they improve the optics of your tax return. And these “faux” wages can be reported on next quarterly 941 tax return.
Note: We describe in another blog post how to report shareholder-employee health insurance.
Tip #4: Round-trip Some Money
Another idea, which more folks should consider…
If you have any way to put funds back into the S corporation and can then immediately return those funds to the shareholder as payroll, that can help you fix the unreasonably low compensation problem.
For example, say you have a credit card with $10,000 of available credit. If you take a cash advance for $10,000 and use those funds for $10,000 of payroll, you’ll partially address the shortfall.
Note: Because of the employer and employee payroll taxes, $10,000 of wages require more than $10,000 of cash. The 15.3% combined employer and employee Social Security and Medicare taxes, for example, mean that $10,000 of payroll costs at least $10,765. But the cash you return to the shareholder-employee equals $9,235.
A tangential comment: You can of course combine techniques. So, maybe you use tip #2 to re-categorize a previous quarter’s distributions and get $16,000 of wages in that way. And then maybe you get another $10,000 of wages by using Tip #3. Finally, maybe you get $10,000 of wages or whatever by using Tip #4.
Tip #5: Talk with Your Accountant about Reporting Wages without Actual W-2s
One last half-crazy idea some accountants will consider: You and your accountant may decide to report wages on your 1120S tax return anyway (even though you didn’t actually do payroll). When you do this, you then report the income as subject to self-employment taxes on your 1040 return.
In this case, if you do the bookkeeping correctly, you pay all the income taxes owe and you pay all the Social Security and Medicare taxes you owe.
Note: The one tax you “short” the IRS is the federal unemployment tax, which runs $420 a year or less. You only short the IRS on FUTA, though, if you pay zero real owner wages.
Let me be clear. This approach clearly breaks the rules. Many CPA firms (including our CPA firm) won’t do this. But some will. And to be objective, this approach probably is the lesser evil in some situations.
A Little Sidebar Here about Tip #5
Let me provide a bit more context too…
At an IRS symposium for several hundred tax practitioners a few years, a CPA stood up and asked one of the IRS’s internal S corporation experts about this “no actual W-2 wages” technique.
The IRS employee responded, “Yeah, you’re not supposed to do that.”
The CPA, a nice woman, answered “I know that. But how bad is it if we have a client do this.”
The IRS employee then repeated his “You’re not supposed to do that” comment. Which she answered with her “I know that but how bad is it” comment.
And they went around like this several more times.
My takeaway? Absolutely, people shouldn’t use this hack. But the IRS S corporation expert seemed to suggest that though IRS would never condone the sloppiness, they probably weren’t going to spend too much worrying about situations like this.
And two related tidbits for tax accountants reading this and now wondering if I’ve fallen off my rocker. If you look at the 1120S form instructions for reporting shareholder-employee wages, you can squint and in the right light read the instructions to say you do have to do this. You can’t in other words not report at least reasonable wages.
Also, it looks to me as if the professional tax software programs provide check boxes to allow just this sort of tomfoolery.
Again, I am not saying this hack qualifies as a good idea. Like I noted, we won’t do it. But I understand the logic of the folks who do.
Two Final Comments
Two final comments. First, if you find yourself with a late S corporation payroll problem, make the experience a learning moment. Do a better job going forward next year.
Tip: Probably the best practice? Outsource the payroll to one of the popular payroll services. (We use Gusto, by the way. For what that’s worth…)
Second, if you just can’t deal with the shareholder payroll thing? Maybe you dissolve the S corporation and go back to operating as a sole proprietorship or partnership. That dissolution saves you from having to do owner payroll.