S Corp Catch-Up Bookkeeping: Draws, Payroll, Personal Costs

What do S corp catch-up books need to show for Form 1120-S?

The books must support each figure on Form 1120-S and on each shareholder's Schedule K-1: officer pay, distributions, loans to and from shareholders, and a year-end balance sheet that agrees with the corporation's books and records (Form 1120-S instructions).

Line and item numbers are from the current form. For an earlier year, use that year's own form: the Schedule K-1 item for loans from the shareholder has a different letter in some years and is absent from others (2020 K-1; 2018 K-1).

Line 19 on Schedule L should generally reconcile to the sum of the K-1 loan amounts. A corporation whose total receipts and year-end total assets are each under $250,000 answers Yes to Schedule B question 11 and need not complete Schedules L and M-1 (Form 1120-S). The books must still be sufficient to establish the items on the return (26 CFR 1.6001-1).

A case is not simple when money went to an owner and no payroll ran, a due-to-shareholder balance has no note, the company paid personal costs, shareholders received different amounts, several years are open and filed returns rest on the old books, an IRS or state notice has arrived, the Form 1120-S is due and the books are not ready, or a preparer has asked why distributions exceed profit. In those cases, the order of the rebuild and what each owner transfer was for come first; the last section routes each case.

Gather first: bank and card statements for every account and month, including any personal account that took customer payments or paid business costs; payroll reports for each year, or confirmation that none exist; prior Forms 1120-S with K-1s and the S election acceptance letter; the shareholder list with dates; loan papers and any written agreements between owners and the company; Forms W-2 or 1099 issued to owners; each shareholder's filed personal returns and basis schedules; any IRS or state notice.

Where do I start when several years of S corp books are behind?

Work the oldest year first and finish it before the next, because each year's closing balances are the next year's opening balances.

1. Confirm the S election took effect. Find the IRS acceptance letter for Form 2553 and its effective date. A missing letter alone does not undo an accepted election; the IRS can reproduce it on request (Rev. Proc. 2022-19). If the election was late, or a shareholder was not eligible (an S corporation cannot have a nonresident alien shareholder or more than one class of stock), the corporation may have been taxed as a C corporation for those years. An LLC whose corporate classification never took effect may instead have been a disregarded entity or a partnership (Form 2553 instructions; IRS: LLCs). Settle that first; see late S corporation election relief.
2. See what the IRS has on file. A Business Tax Account shows the balance by year and tax transcripts; the designated official also sees IRS notices and letters. That official must be an officer or managing member, a current employee who received a Form W-2 for the most recent filing year, and authorized to bind the corporation, so a corporation that never ran payroll may not qualify. A shareholder with a K-1 can register for limited access to the balance and transcripts. List each year's returns as filed, unfiled or under notice.
3. Set the starting point. Treat the closing Schedule L (if the return has one) and K-1s of the last filed return as balances to test, not as proof.
4. Reconcile cash to statements. Every bank and card account, month by month, and any personal account that took customer payments or paid business costs.
5. Park owner money. Put each transfer to or from an owner, and each personal-looking charge, in one temporary account instead of picking a label.
6. Classify the parked items, year by year: wages, distribution, loan, capital contribution or loan repayment. This drives payroll, equity and basis, so it comes before them.
7. Build payroll for any year with wages: wages, withholding, employer tax, and liabilities cleared against deposits. List the returns still to file.
8. Build the shareholder accounts: distributions by shareholder, the due-to and due-from roll-forward, and the basis schedule.
9. Tie the year to its return. List each difference from the filed Schedule L and K-1s with its cause, then start the next year.

Steps 6 and 7 are where cases stop being simple. The sections below cover each.

Does catch-up bookkeeping take longer for an S corp with payroll?

Yes. Payroll adds work to S corporation catch-up books in every year that has wages, because the books must also tie to Forms W-2 and W-3, each quarter's Form 941 and its deposits, Form 940 and state returns. Every year also needs the decision on what each owner transfer was for. The number of years behind, missing statements, personal charges to classify, shareholder loans with no paper and filed returns that need amending drive the time and the fee as well; see catch-up bookkeeping cost and S corporation accounting cost.

Why does the IRS treat owner pay as wages when I only took draws?

An officer of a corporation is generally an employee for Social Security and Medicare tax and for income tax withholding, with a narrow exception for an officer who performs no or only minor services and is not entitled to pay (26 U.S.C. 3121(d); 26 U.S.C. 3401(c); IRS: paying yourself). Pay for an officer's services is therefore wages, whatever the bank memo or the books call it.

The IRS tells S corporations to treat payments for officers' services as wages, not as distributions of cash and property, payments of personal expenses or loans (FS-2008-25). "Draw" is not one of those categories, so a ledger account named owner draws still has to be sorted into them. The same holds for member draws in an LLC that elected S corporation status: it reports on Form 1120-S, with units in place of shares (Form 1120-S instructions).

• Who. An officer who performs more than minor services and receives or is entitled to pay is an employee, and being a shareholder changes nothing (IRS: officers).
• How much. An S corporation must pay reasonable compensation before it makes non-wage distributions, and reasonable pay never exceeds what the shareholder received (IRS: compensation issues). No specific guidelines exist, courts decide on the facts (FS-2008-25), and the corporation's intent to limit wages does not control (IRS: officers).
• Which part. To the extent receipts come from non-shareholder employees and from capital and equipment, payments to the shareholder are properly distributions. To the extent they come from the shareholder's own services, they are wages, and so is pay for administrative work the shareholder does for those employees or assets, such as managing them. The IRS can reclassify distributions as wages (IRS: compensation issues).

Money taken only as draws may therefore be part wages and part distribution. The split is a judgment about the work done; see S corporation owner salary for sizing. A journal entry alone does not report wages: they reach the IRS through payroll returns, so the books and the returns have to agree.

How do I sort big transfers to me: wages, distributions or loans?

Sort each transfer by what it was for. Pay for services is wages. A loan or a loan repayment needs real terms. A payment with respect to stock is a distribution (section 1368(a)). Payments for rent, interest, goods bought from the owner or costs the owner paid, on real terms, are not payments with respect to stock.

The loan test comes from the IRS (IRS: paying yourself), which also says a below-market loan can be treated, depending on substance, as a gift, dividend, contribution to capital or payment of wages. Purported loans have been treated as wages where they were unsecured demand notes with no interest, made at the owner's discretion to an owner doing substantial work, and repaid only by a paper credit (IRS: officers).

Which label fits turns on facts only the owner and the documents can show: the work done, what was agreed when the money moved, and how it was repaid. Repaying an owner for business costs the owner paid is a separate case; see reimbursing owner expenses.

What do I do about a large amount of owner distributions?

Test each year's distributions three ways before they stay labeled distributions.

• Was reasonable pay paid first? Reasonable compensation comes before non-wage distributions (IRS). If not, return to the section on sorting transfers.
• Do all shareholders hold identical rights to distributions? Distributions, including constructive ones (benefits that act like a payout, such as a personal bill the company paid), that differ in timing or amount get appropriate tax effect (26 CFR 1.1361-1(l)(2)). See unequal distributions.
• Does each shareholder have basis to cover them? A distribution is tax free up to stock basis and the excess is gain (section 1368(b)). See distributions in excess of basis.

A distribution larger than the year's profit does not by itself decide the tax effect. Basis does, and for a corporation with accumulated earnings and profits from a C corporation year, section 1368(c) adds an ordering rule. An election can put earnings and profits first: all shareholders who received a distribution consent, and a statement goes on a timely filed original or amended Form 1120-S for that year (section 1368(e)(3); 26 CFR 1.1368-1(f)). Each amount must also tie to the bank and to K-1 box 16, code D; see recording distributions.

What do I do with personal costs the S corp paid?

Personal, living and family expenses are not deductible (section 262). A personal cost the company paid gets one of the same labels as any other transfer to an owner: wages, a distribution, a loan, or a repayment of the owner's loan. The IRS cites a court decision in which an owner's personal use of the company bank account led to employment tax, and another in which personal expenses the corporation paid for a shareholder were treated as pay for the shareholder's services (IRS: officers).

1. List each personal charge from the statements, by owner and year. For a mixed item such as a car or phone, only the business share stays an expense.
2. Move the personal charges out of the expense accounts into the parked account, and label each using the tests in the sorting section.
3. Check whether a filed return deducted them. If so, the deduction may have to come out; see correcting a filed business return.

The rules for each label are in S corporation paying personal expenses.

What is due to shareholder, and how do I reconcile it?

A due-to-shareholder balance is a catch-all account. The return splits it into loans from the shareholder, loans to the shareholder, capital contributions, distributions and wages, so the reconciliation has to split it too.

To reconcile it, export every posting with its bank or card line, give each a row in the table, then roll the account forward by shareholder and year: opening balance, plus advances, less repayments, equals closing balance. Compare each closing balance to K-1 item I and Schedule L lines 7 and 19 on the filed return.

Keep loans to the owner and loans from the owner apart. The basis of an owner's loans is generally the balance the corporation owes the owner, so money the corporation lent the owner adds none (Form 7203 instructions). Advances an owner makes with no written note are open account debt, one account for each shareholder, netted at year end (26 CFR 1.1367-2(d)(2)). A shareholder's year-end balance owed to them above $25,000 is treated like a written note from the next year (26 CFR 1.1367-2(a)(2)). Money the corporation advances to an owner is not covered by that rule.

The IRS cites a court decision in which a sole shareholder's earlier transfers into the corporation were treated as capital contributions, not loans, and the corporation's later payments to that shareholder as wages, not distributions or loan repayments (IRS: officers). Whether a balance is a debt depends on the facts, and a large balance with no paper is a call for a professional. To decide whether money an owner put in is a loan or capital, see shareholder loans to an S corporation.

Do rebuilt books have to match the Schedule L on returns already filed?

Nothing in the Form 1120-S instructions requires new books to copy an old return, but Schedule L is meant to agree with the corporation's books and records (Form 1120-S instructions). A gap between the rebuilt year-end balances and the filed Schedule L means the old books, the old return or the rebuilt books are off, and each gap needs a cause. If the filed return answered Yes to Schedule B question 11, it has no Schedule L; tie the rebuilt year to the K-1s, the payroll returns and the bank statements instead.

1. Line up each rebuilt year-end balance with the filed Schedule L and K-1s: cash, loans to and from shareholders, and equity.
2. Give each difference a cause: an old-books error the return did not repeat; an error on the return, such as wages never reported or a personal cost deducted; or only a difference in how accounts were grouped.
3. For an error on the return, file an amended Form 1120-S with the amended-return box checked and a statement of each changed line, the corrected amount and the reason. Send an amended K-1 to any shareholder whose K-1 was wrong. A change may also affect the state return (Form 1120-S instructions).
4. A shareholder reports K-1 items the way the corporation did (K-1 instructions), so one who already filed may need a separate Form 1040-X for each year that changes (Form 1040-X instructions). Newly reported wages, changed distributions and a changed basis can all reach those returns and later years.

A plug in equity hides a gap instead of explaining it; see S corporation balance sheet not balancing. To correct a return and its K-1s, see correcting a filed business return.

Which years of payroll returns and W-2s must be caught up, and what penalties follow?

A year needs payroll returns when money paid to an officer who performed more than minor services is treated as wages in that year. The years follow from the classification, not from how old the books are. Whether and how past draws are treated as wages depends on the amounts, the pay dates and what was already filed.

For each such year with no payroll returns filed, the corporation files an original Form 941 for each quarter from the first with wage payments, on the form revision for that period (Publication 15). It then files for every later quarter, even with no wages, unless it filed a final return or is a seasonal employer. Form 944 replaces Form 941 only if the IRS notified the corporation to file it (Form 941 instructions). Forms W-2 and W-3, and Form 940 and state returns where required, also follow. Form 941-X corrects a Form 941 already filed, and Form W-2c with Form W-3c corrects a Form W-2 already filed (W-2 instructions). If the filed Form 1120-S took no deduction for those wages, an amended Form 1120-S and K-1s follow.

For a quarter with no Form 941 on file, the Code lets the IRS assess the tax at any time (section 6501(c)(3)). Once a Form 941 is filed, the usual period is three years from April 15 of the next year, or from the filing date if later (section 6501(a) and (b)(2)). The IRS manual applies the same periods to the trust fund recovery penalty (IRM 5.7.3.6).

The IRS also charges interest on penalties (IRS: failure to pay penalty).

A corporation that treated an employee as a nonemployee is generally liable for the tax it did not withhold. Special section 3509 rates may apply, depending on whether required Forms 1099 were filed. They are not available for intentional disregard of the withholding requirement, or where income tax was withheld but not Social Security or Medicare tax (Publication 15). The IRS says that includes a corporate officer who treats himself or herself as a nonemployee (IRS: paying yourself). Relief and notices are covered in behind on payroll taxes.

How do loans and distributions tie to stock and debt basis?

Distributions reduce stock basis and an owner's loans to the corporation create debt basis. Money the corporation lends the owner creates neither, so the books must separate them before basis can be built.

Each shareholder keeps the basis records, and a shareholder who received a non-dividend distribution or a loan repayment files Form 7203 with the return (Form 7203 instructions, the source for the table). The books supply the dates and amounts. Build the schedule from the first year of ownership forward: each year's beginning stock basis equals the prior year's ending basis.

Gain on repaying a loan whose basis losses reduced is capital gain on a formal note and ordinary gain on open account debt. The Form 7203 instructions treat an open account balance above the limit both ways: as a formal note for the gain, and as open account debt with ordinary gain. That repayment is a call for a professional. For the basis schedule and loan terms, see S corporation shareholder basis and shareholder loans to an S corporation; for distributions above basis, see distributions in excess of basis.

Example

These examples are illustrative; all amounts are in US dollars.

One owner, two years, no payroll

A one-owner S corporation earns US$150,000 of profit in each of 2 years. The owner works in the business full time and moves US$120,000 a year out of the business account, booked as "owner draws". No payroll ran, and both Forms 1120-S were filed from those books.

Work year 1 first. Park the US$120,000, then decide what it was for. Suppose a review of the owner's duties and of where the receipts came from supports US$60,000 as reasonable pay. Year 1 then has US$60,000 of wages, with payroll returns, and US$60,000 of distributions. Profit before employer payroll tax falls from US$150,000 to US$90,000. Year 2 opens from the corrected year 1 balances and is worked the same way. A different review could support a different split, and no share of owner money is a safe wage figure. Which years need payroll returns, and whether the filed returns are amended, are the questions to settle before the year 2 balances are built.

A 50/50 corporation pays one shareholder's bills

A 50/50 S corporation paid US$30,000 of one shareholder's (A) credit-card bills and car costs. The statements show US$24,000 personal and US$6,000 business. The US$6,000 stays an expense. The US$24,000 needs a label:

If the books had deducted the US$24,000, a distribution or loan label removes that deduction, so each owner's share of income rises by US$12,000 at 50/50, including B's, who received none of it. Wages stay deductible.

Put in US$40,000, took out US$90,000

An owner put US$40,000 into the corporation in year 1 with no note, then took money out in each of 3 years. The due-to-shareholder account runs year by year:

If the first US$40,000 was a loan and the records show the US$10,000 and US$30,000 taken out in years 1 and 2 were repayments, those payments extinguish it, and the year 3 US$50,000 is not a repayment, so it needs a label of its own. Without that proof, the years 1 and 2 withdrawals also need a label: wages, a distribution or a repayment. The year 1 balance owed to the owner is also above the open-account limit, so from year 2 it is treated like a written note for basis. If the US$40,000 was a capital contribution, none of the US$90,000 is a repayment and all of it needs a label. Either way, the basis schedule is built from that answer, year by year.

Different for you?

• The Form 1120-S is due and the books are not ready: the order of the rebuild and the question of what the owner's pay was for come first. A calendar-year corporation's return is due March 15 of the next year, or September 15 with a timely Form 7004; see extension when the books are not ready. If the rebuild is more than you can finish in time, see bookkeeping help.
• The IRS sent a payroll or penalty notice: read behind on payroll taxes. If the notice covers years whose books are behind, see bookkeeping help to rebuild them in order.
• Your preparer asks why distributions exceed profit: the owner's pay, any payroll years and basis all feed that answer. See distributions in excess of basis, and bookkeeping help if the books behind it are not rebuilt.
• Several past years have no payroll and filed returns rest on those books: the oldest year is rebuilt first and each year is tested against its return. See bookkeeping help.
• You cannot find the S election acceptance letter: see late S corporation election relief.
• Returns for earlier years were never filed: see catching up on unfiled business returns.
• Two or more shareholders received different amounts: see unequal S corporation distributions.
• You never ran payroll this year: see S corporation payroll never run.
• Past years were filed on Schedule C by mistake: see S corporation reported on Schedule C.
• The balance sheet will not balance: see S corporation balance sheet not balancing.
• You want a routine for repaying owner-paid costs: see reimbursing owner expenses.