How to handle a missed reasonable compensation payout

Working with S-corp clients often means balancing compliance with smart tax planning. When compensation isn’t properly handled, you need to evaluate options like adjusting payroll and managing health insurance benefits to bring the client back in line. 

Recognizing the financial and regulatory implications early lets you protect both your client’s bottom line and your professional credibility.

Below, you’ll find a few of the top questions from a recent webinar on the topic and their corresponding answers. If you choose to watch the on-demand version of this webinar, you can access the full recording and the entire list of Q&As.    

Q: Can an S corporation retroactively treat shareholder distributions as wages after year-end?
A: No. After the year closes, neither a practitioner nor a taxpayer can reclassify distributions as wages. Wages must be paid and reported during the tax year through normal payroll processes, including withholding, depositing payroll taxes, and issuing a timely Form W-2. However, while an S corporation could technically file late payroll returns, doing so does not recharacterize prior-year distributions as wages, and it exposes the taxpayer to significant penalties. The IRS expects wages to be paid in the year services are performed. Therefore, the proper remedy is to correct prospectively, not retroactively.

Q: What happens if an S corporation doesn’t issue a W-2 to the shareholder-employee?
A: If the S corporation fails to pay reasonable compensation and does not issue a W-2, the IRS may reclassify shareholder distributions as wages during an audit. This reclassification can result in back taxes, penalties, and interest related to employment taxes.

Q: How can a practitioner correct a lack of reasonable compensation reporting in a prior year?
A: Practitioners cannot fix this by filing a W-2 after year-end. Instead, they must advise clients on improving compliance going forward. If audited, the IRS may make adjustments that are unfavorable to the taxpayer. Documentation of reasonable compensation going forward is essential.

Q: Can a corrected or late W-2 be issued for a prior year to show wages?
A: No. A corrected W-2 (Form W-2c) can only be used to correct already issued W-2s. You cannot issue a new W-2 after year-end to reclassify prior-year distributions. Doing so may be seen as an attempt to backdate wages, which could expose the taxpayer to IRS scrutiny.

To learn more about what to do if your client didn’t take reasonable compensation last year, you can watch our on-demand webinar. NATP members can attend for free, depending on membership level! If you’re not an NATP member and want to learn more, join our completely free 30-day trial.