Missing Payroll, Now What

By Jason Watson, CPA
Posted Tuesday, October 31, 2023 (boo!)

There is a near certainty that we can make the S Corp election retroactive to January 1 of 2023. As mentioned earlier, one of the pillars of S Corps is to pay a salary to the materially participating shareholders. If you are reading this after Thanksgiving dinner and yet another tragic Cowboys loss, it is time to step on the gas and get payroll setup so a payroll event can be processed before the end of the year.

But if it’s 2024, and 2023 is all over, there are three options (in descending order of elegance)-

Issue a 1099 to Yourself

Really?! For real? Hang in there on this one (in all fairness we did allude to this earlier). What we can do is issue a 1099-NEC for a portion of the business net income to yourself which will be reported on Schedule C of your individual tax return (Form 1040). In turn, this income will be subjected to self-employment taxes. Remember self-employment taxes and Social Security and Medicare taxes are the same thing.

The amount of the 1099-NEC is entered into Line 7 of Form 1120S as Officer Compensation. Therefore, from an Officer Compensation to net business / K-1 income comparison, this technique still satisfies the reasonable salary sniff.

While the IRS might frown upon this option, at the end of the day they are typically satisfied since employment taxes are essentially being paid. Again, this is not as elegant as the W-2 option, but it certainly works for the first year.

Additionally, if you were to lose an IRS challenge on reasonable salary determination the IRS would impute income on Schedule C. We are simply following what they would eventually do anyway. Again, this is a first-year mulligan. A one and done. Payroll must be set up for the following year, and normal W-2 and other filings must be done.

Who should lose their mind with this solution is the state since unemployment and other insidious taxes such as state disability insurance (SDI) is not being paid. Then again, we’ve never heard of a state challenging this either.

Manual Late Payroll Event

WCG used to do late payrolls since we processed payroll manually, in-house. Currently, we are partnered with ADP to handle all our payroll processing (we still consult with you on a reasonable shareholder wage and make the payroll entries into ADP). ADP is wonderful, but they are rigid. As a result, no late payrolls.

We list this option is case you or someone else wants to run a late payroll event after December 31, but we advise against it. If you want to see a flurry of IRS and state notices, and waste time wading through it all, then go for it.

Roll the Dice

As paid tax professionals, WCG cannot advise this course of action. Having said that, we have observed several taxpayers labeling the first year as a mulligan, not creating a W-2 or a 1099, and taking his or her chances. Audit rates are about 0.4% for S Corps, and currently the Treasury Inspector General of Tax Administration (TIGTA) is charging the IRS with the task of auditing S Corps that do not pay a salary and who report losses for three or more years. As a result, profitable S Corps appear to be flying under the radar especially if you only miss one year of paying a salary (your first year).

What could happen? The IRS could simply impute wages, create payroll liabilities and send you a bill. We’ve seen S Corporations get these types of notices. This is not ideal since the state is not getting its share of things such as unemployment and disability, and the IRS is sharing data with states.

Again, rolling the dice is not our professional advice, even if it rhymes. We do not want some stray bullet from the IRS hitting us while trying to hit you- we will decline the engagement if you want to roll the dice. We don’t want your problems to become our problems (sorry).

Conversely, let us do it right. You sleep well at night. More rhymes. Everyone wins.

Of course, we can take care of all this paperwork for you!

Huge Emphasis: We cannot stress enough that having an LLC in place is cheap insurance even if you don’t ever elect to be an S Corp. While IRS guidance is hazy, it is our recommendation plus the recommendations of tax attorneys and other consultants that the effective date of the S Corp election should not occur before the earliest date that the LLC has members, acquires assets or begins conducting business.