Discussion:C Corp Distribution/Salary Question (Big Mess)

The owner had intended to be a s-corp but had neglected to file the 2553 and at this point is ineligible for relief under rev. procedure 2004-48. The owner had made distributions to themselves from the company, and at this point are claiming that the monies taken out were "loans." If this indeed is the case, what kind of documentation is needed to substantiate this? The owner is facing double taxation on the distributions, and I feel uncomfortable signing off on his 1040 unless he provides documentation. Do the loans need to have been notarized?

Also, the owner neglected to pay himself a salary. Obviously, he contributed to the profits the corp earned, as the business would not have existed without him. On the c-corp return,do I still put in a "reasonable salary" as compensation? And if this is the case, can I just have him pay a self-employment tax to cover the payroll taxes that should have been paid (and be prepared to have him pay penalties for not turning in form 941). Or do I just leave the salary at zero?

Worst case scenario, the owner would have to pay an additional 30 grand if the salary is set at $0 and the "distributions" are classified as dividends.

Please advise!

Thanks...

Forget "reasonable salary". I would just put it in the corporate minutes that the corporation authorized $xx,xxx of salary, that was not paid.

During the following fiscal year, the corporation can pay bonuses for the purpose of paying down the loan. It is usually easy to generate a net operating loss this way and carryback the NOL to obtain a tax refund. Most states don't refund taxes on a carryback of NOL, is CA the same?

If the owner intended to pay himself compensation without paying P/R taxes, it's time to educate him.

Also, thanks for the feedback everybody, particularly Marcilio. I'm sure my client will be happy to hear about the demand note. However, putting down zero compensation, even if it is advisable, strikes me as being a little unrealistic, as the owner did do work for the corporation. And, wouldn't the IRS want to collect payroll taxes?

p.s. Hope everyone had a great 4th!

We just don't know everything about how the IRS selects corporation returns for audit.

But, in your case, if you have the note documentation in place, and by the time an audit takes place would have repaid the loans, via converting them to taxable payroll, your client will be in as good a position as possible.

Your other alternative, going back & filing late payroll tax returns for 2006 would be extremely costly, and not absolutely necessary if the client can show intent to treat the distributions as loans, including paying them back quickly.

Perhaps the dividend route wouldn't be the end of the world, when compared with payroll taxes on current year bonuses used to finance the repayment of the loan. I believe this would be safest, in terms of red flags.

One thing I'm quite sure of is, with a C corporation, the IRS doesn't care about a lack of owner compensation. In fact, they're more concerned with excess compensation.

Good luck!

A couple of questions:

1) The client didn't start running payroll until this year. Can I assume that the bonuses have to be run through payroll, and therefore the bonuses can't begin to be paid until this year?

2) Also, during 2006, there were actually $208K in withdrawals from the client and $65K in deposits to arrive at the $143 loan amount. Have I assumed correctly that the deposits count against the withdrawals to get a "net withdrawal" amount to use as the loan figure?

Thanks again!

So at the end of 2006 the client owed the corporation $143K. As Marcilio said above, make the note for the $143K with an attached schedule showing the withdrawals and the deposits netting to that amount.

On the corporation's books, debit payroll expense (along with the tax withholdings, FICA, UI, DI, whatever) and credit the note receivable. Over a period of time the note will be paid off, all the appropriate employer taxes will have been paid, and all will be well. Don't let it drag on too long, though.