What Tax Form Do I Issue Partners in an S-Corp?

[Hobbyist]

A partner and I are 50% partners in an S-Corp.

What tax form should the S-Corp issue its owners to input in their personal returns?

I may have done it incorrectly, but Turbotax Business spit out a K1 form to both partners. There was a field for "W-2 Wages" in the K1, but even after entering the K1 information, it didn't change the amount of tax that I owed.

I tried typing in a W2 form and even issuing myself a W-2, and it adjusted it correctly.

However, I didn't withhold anything all year with the understanding that it would be owed with a penalty when I filed my taxes and I'm fine with that.

After discussing with a tax professional, he said I shouldn't be issuing myself a W2, and that the K1 information should have been enough for Turbotax to figure it out.

He said if I issue a W-2 then I would owe Social Security and Medicare taxes, plus interest, plus penalties if I issued myself a W-2 without withholding, but I thought I had to do that anyways?

So did I do it incorrectly, or do I need to issue myself a W-2 or a 1099 kind of form?

[DavidD66]

An S-Corporation (or an LLC taxed as such) issues all of the owners/members a K-1 which reports their share of income, gains and losses, distributions to owners, and other information needed to be reported on the shareholder's tax return.  

To prevent S corporations and their shareholders from avoiding payroll taxes by maximizing distributions and minimizing compensation payments, the IRS requires S corporations to pay shareholders who provide substantial services reasonable compensation.  This means that, as an owner, you also have to treat yourself as an employee, and pay yourself as an employee.  That also means withholding taxes, social security, and Medicare.  It also means reporting those payments on a Form W-2.  If your S-Corp's profit is not significant, you may be able to get away without paying yourselves a salary, but if you're making money, you should start paying yourself a "reasonable" salary right right away.

Do not issue yourself a Form 1099-NEC or 1099-MISC.

[Hobbyist]

Thanks for the reply.

We are in a house flipping business, so we split the profits 50/50 after closing each sale.

We did not withhold anything all year knowing we would owe those taxes on the return.

I read about the 60/40 rule, so on Turbotax I put in 60% for salary, and 40% distributions on everything, and I zeroed everything out after deductions to make a net profit of 0.

So you're saying in addition to the K1, I need to issue each owner a W-2 form? Because my tax consultant said not to do that.

When I was generating the W-2 it said since I put 0 for social security and medicare taxes that it would be a red flag. But if I issued it as a1099-Misc instead, I wouldn't be required to withhold anything.

So do I have to issue each owner a W2?

[DavidD66]

No, what I was saying is that as an S-Corp, you SHOULD have been paying yourself as a W-2 employee.  That means withholding taxes, social security, etc.  You then would have to send all of your employees (even if you're the only ones) a W-2 that reports all of the payroll information.  But you didn't treat yourself as an employee. You didn't pay yourself and withhold taxes, social security, and Medicare.  Unless you were to go back and pay yourself as an employee retroactively, there is nothing to report on a W-2.  

It is possible the IRS will come back and deem some of what you earned during 2020 as "salary".  If that occurs, both you and the business will have to pay social security and Medicare tax, plus penalties and interest on that salary.

[Hobbyist]

Thanks. Yes I know that I was suppose to be withholding, but it was my first year in business so I'm learning, making mistakes.

So what should I do now? I was suppose to pay myself 60% in salary, and 40% dividends/distributions and that was how I did it in the K1.

What should I issue myself now then? A W2? A W2 and a 1099? Or just a 1099? Or something else?

[DavidD66]

Unless you are going to make corrections retroactively, you will issue yourself and your business partner a K-1.  

[Hobbyist]

Edited: I realize now what you were saying after correcting my K1.

You're saying to not issue myself a W2 and to take 0 salary and make everything distributions/dividends correct?

Wouldn't that raise a red flag though. Because I'm suppose to pay myself a "reasonable salary." And it's typically suppose to be around 50-60% of the total net income of the S-Corp.

Then the IRS will reclassify part of my income as salary and I'll have to pay the extra taxes and interest anyways right? So what would be the benefit of not issuing a W2 if the IRS is going to reclassify it anyways?

Is it because they'll pick whatever rate they deem appropriated, which will probably come in slightly lower than the 60% I was planning? Or is it the possibility that I won't be levied penalties for not withholding the Social Security and Medicare taxes?

[Hobbyist]

I edited my prior response. Hopefully you or someone else can help clarify this last thing.

Thanks in advance.

[JeffreyR77]

My suggestion for a first year S-Corp in the COVID environment is to recognize now the reasonable compensation process wasn't followed correctly. 

Issue 1099-NEC to all parties that should have been on payroll during 2020. 

They will have to file Schedule C and pay the full Self-Employment tax for 2020. 

You can make that consideration when you determine how much  to write the 1099-NEC for. 

This step shows you recognize the error, and attempted to correct as best you could at time of discovery.  You cannot do retroactive payroll.  (Start payroll for 2021 now.)

The amounts of the 1099--NECs are business expenses and will reduce S-Corp income that will pass through as income to the members in the same way compensation would have.