Shareholders invested $300K in S Corp, took years of losses that became NOLs. Last year they finally made a profit, but did not take wages, only return of capital they needed to live on. Are they required to go back and file W2s?
The idea behind the corporate shareholder requiring wages is that a corporation - Sub S or C - is a separate entity from the shareholders under state law AND you cannot run a for profit business without paying your workers. That is why corporations are required to pay a salary to all employees (including owners) which is commensurate with the amount that employee would expect to be paid by an unrelated corporation. IE if an engineer goes into business for himself doing the same type of designs he did for, say, Boeing for $100K per year, then he is expected to take a salary commensurate with that amount from his own corporation. So that's just an explanation of what these S-Corp shareholders are supposed to do.
Real life however - did the shareholders take out any monies or compensation (such as the corporation paid for their personal vehicle, paid for their DirecTv or some other expenses?) other than this return of capital? If yes, then the value of those monies or compensation could be considered wages.
Do you want to go back and file the W2's? A creative way around it is to drop the value of the considered wages onto a Schedule C with no expenses against it. In this way the IRS gets their FICA tax paid, and that is what they are really looking for. I have spoken to people who have done it this way after the fact and had the methodology hold up in an examination by the IRS. It isn't the right way, but the end result was the same... FICA tax was paid on the value of fair and reasonable wages, and it is the FICA tax that the IRS is looking for.
Just a thought - any corporation in business with no wages whatsoever has a great big target on their back. It is not easy to spot the undervalue of wages paid except in the event that NO WAGES are paid... that's a no brainer. The corporation is not in conformity with the law.
I have to say that your explanation for officer compensation is very well said however the Schedule C advise may cause problems. The IRS may have let it go in a review only because there would be no tax consequence but the WAGES are not self employment and are therefore taxable for unemployment Insurance and possibly workers comp in some states. The best way to handle it is first of all. make sure all loans or capital contributions are well documented in the books. If there are wages they can be reported in the 4th quarter only and have no issues with the feds or the states.
I have a situation where client has S-Corp earnings but has not taken anything out of company. He has been working (living off wife's earnings) without pay until he pays off $1million bank debt. Until the bank's paid off he is not taking anything out. I assume he is OK doing this?
No cash out, no way for the IRS to reclassify it as wages on audit. You're OK doing it that way.
You can't take cash out and call it return of capital in hopes of avoiding the statutory employee treatment of corporate officers. You cuold call it loan repayment, maybe, if you had called the original money a loan when it went in. But if you've got lots of losses, you've likely got debt basis less than face, so will have income on the repayment.
You may also want to check your state law; in my state, corporations may not pay state-law dividends other than out of retained earnings, and a return of capital might run afoul of those rules.
