Is it going to raise a flag if our S-Corp distributions are much higher than the calculated profit for the year?

[alohaTy]

Our owner distributions (beyond wages) were almost $50,000 total more than what TurboTax is calculating as our "ordinary income" (profit) last year. Will this raise a red flag with our return?

FYI, we paid ourselves more after underpaying ourselves in previous years.

[MinhT · Accepted solution]

No, distributions much greater than the year's profit would not necessarily raise a red flag with the IRS.

As you said yourself, these distributions could represent profits not yet distributed from past years.

[alohaTy]

However, I'm seeing now on our Schedule M-2, Line G, that we have a significant "Distributions in excess of Retained Earnings". Will this raise a red flag? If this is unusual and could trigger an audit, then perhaps we didn't carry over retained earnings properly in past years (last year we transitioned from LLC to S-Corp, and RE may not have properly carried over).

Also, I'm surprised that line C equals line F, even though the ending balance should probably be negative since our distributions this year exceed the beginning Retained Earnings plus the Net Income...

Thanks.

[MinhT]

The number to watch is Shareholders' Equity at year end (total of lines 22 to 26 on the balance sheet - Schedule L.
If this total is not negative, this generally means there were no distributions in excess of bases.
You should review all numbers in Shareholders' Equity, not just retained Earnings.

[alohaTy]

On Schedule M-2, under Accumulated Adjusted Accounts column, rather than automatically inputting the correct distributions from Schedule K (Items Affecting Shareholder Basis: Shareholder Distributions and Dividends), it only does the Ordinary Income amount as the distribution, as if it knows it cannot be more than that. This causes an imbalance, which carries over to the Schedule L Balance Sheet. It seems retained earnings at the end of the year should be negative (Beginning Balance in Retained Earnings plus Ordinary Income minus Distributions).

Again, I think it's negative since it appears we had some retained earnings from years ago that never got carried over properly as we switched tax structures.

So, 1) how can I fix this imbalance (TurboTax says it must be fixed), which seems to be driven by the Schedule M-2 entries as described, and 2) how do I best avoid an audit given this issue?

Thank you!

[MinhT]

You need to consult with your accountant to correct the balance sheet and ensure that Schedule M-2 has been correctly reported for previous years. Once the amounts in Schedule M-2 are properly tracked, the balance sheet must be in balance.

[alohaTy]

From a tax perspective (i.e. avoiding a red flag with the IRS), in order to balance this year's balance sheet, am I better off:
1) Changing the beginning year retained earnings to be higher (but it won't match last year's tax return end of year RE balance)
2) Underreport this year's profit distributions (which I don't believe impacts our taxes due)
3) Something else?

I'd like to avoid amending a past year's return...

Thanks!

[MinhT]

Honestly, I cannot advise you on which "error" is better from a tax perspective. It is clear that the balance sheet and Schedule M-2 need to be reviewed by an accountant.