S Corp Paid Personal Expenses: Distribution, Wages or Loan?

Can my S corporation pay my personal bills or taxes, and what does the IRS call it?

An S corporation can send money to cover an owner's personal bill, but the bill itself is not a business cost. Section 262 allows no deduction for personal, living or family expenses. The corporation can deduct the payment only as reasonable pay for services, treated as wages, or under an employee-benefit rule that fits the person (see the health insurance row below); otherwise it reaches the owner as a loan or a distribution. A card or bank statement that says "business" does not decide which. The same holds for an LLC taxed as an S corporation, which files the same Form 1120-S. Owners often call this a draw; the tax labels are wages, loan or distribution.

The IRS says an S corporation should not let an officer treat pay for services as distributions, personal expenses or loans (Fact Sheet FS-2008-25). Test each payment against these labels: was it pay for services, is it a real loan, and if neither, it is generally a distribution:

A payment that is neither pay for services nor a real loan is generally a distribution, even when no one ever called it one (unless it repays money the owner lent the corporation; see the loan section). The regulations recognize constructive distributions, payments that work as distributions without the label, not only checks marked "distribution" (26 CFR 1.1361-1(l)(2)).

A case is not simple when:

• a year-end review turned up personal charges and no one has decided how to label them;
• the owner has no payroll, or pay far below what the work is worth;
• there is more than one shareholder;
• the spending covers several years, or filed returns deducted it;
• the owner's stock basis is near zero, so a distribution can create gain.

The label chosen changes payroll tax, stock basis and possibly returns already filed, so settle the labels before the return is filed. Gather the bank and card statements for every year, the K-1s, the prior Form 1120-S and the payroll records.

How do I sort and record personal expenses paid from the S corp account?

Go charge by charge and ask whether the corporation incurred the cost in running its business. A business cost is deductible if it is ordinary and necessary (section 162). A cost that serves the owner's private life is personal. Steps:

1. Export every bank and card statement for the year, for each account the corporation holds.
2. Mark each line business, personal or unsure. Get the receipt and the business reason for anything unsure. Book an item with no documented business reason as personal until one is documented.
3. Total the personal items by owner.
4. Give each personal item one label from the table above. Do not label a year as a single lump.
5. Move each personal item out of any expense account.
6. List the returns, W-2s and payroll returns that already used the old figures.

The Form 1120-S instructions cover the first three of these common charges:

Is a payment of my own income tax or estimated tax a distribution, and what about state pass-through entity tax?

The owner's own income tax is the owner's liability, so the corporation cannot deduct paying it as a tax. The Form 1120-S instructions tell the corporation not to deduct federal income taxes or taxes not imposed on the corporation on the taxes line. A corporate payment of the owner's tax is then generally wages, a loan or a distribution, the same as any personal bill.

Ask whose liability the payment settled:

Notice 2020-75 covers income tax imposed on the S corporation itself and says taxpayers may rely on it until proposed regulations are issued. A state's rules decide whether a payment is the entity's tax, so check the election confirmation and the payment record. Federal income tax withheld from the owner's wages is different from an estimate sent from the company account; see S corporation estimated tax payments and the EFTPS payment fix.

When must a personal payment be treated as wages?

A personal payment is wages when it was pay for the owner's work, whatever it was called. The Code treats any officer of a corporation as an employee (section 3121(d); section 3401(c)). An officer who performs no services or only minor ones, and neither gets nor is entitled to pay, is not an employee (IRS).

An S corporation must pay a shareholder-employee reasonable pay before it makes non-wage distributions, and the IRS can reclassify distributions as wages (IRS). Three limits:

• The wage amount never exceeds what the shareholder received, directly or indirectly.
• Neither the Code nor the regulations set a formula; the facts decide (Fact Sheet FS-2008-25). See how much salary an S corporation owner should pay.
• The corporation's intent to limit wages does not control. The test is whether the payments were truly pay for services (IRS).

Personal items can themselves be wages. Wages include taxable fringe benefits (Publication 15), and a benefit is taxable unless the law excludes it (Publication 15-B). What wage treatment means:

Wage treatment has to be real: run through payroll and reported for the year paid. For a year already filed, that generally means corrected payroll returns and W-2s, and whether and how to correct depends on the year and the facts; see fixing a payroll mistake and S corporation payroll never run.

When can it be a loan, and what makes it a real loan?

A payment is a loan only if the owner is truly in debt to the corporation. A "loan" label alone does not hold. The IRS summarizes a court decision that treated purported shareholder loans as wages: unsecured demand notes with no interest, made at the shareholder's discretion to an owner who did substantial work, "repaid" only by a bookkeeping credit against amounts the corporation owed the owner (IRS).

A record that avoids those problems shows:

• a signed note stating the amount, the due date or payment schedule, and the interest;
• interest of at least the applicable federal rate, which the IRS publishes each month;
• repayments the owner actually makes under the note and the records show; in the case above, a bare bookkeeping credit was a "paper transaction".

These are common features of real debt, not an IRS safe harbor; the IRS page gives no checklist. Whether the money is a loan depends on all the facts.

Interest below that rate makes it a below-market corporation-shareholder loan under section 7872, and the owner is deemed to receive a distribution (26 CFR 1.1361-1(l)(2)(vi), Example 5). For the small-loan exception, terms and interest, see borrowing from your own corporation.

Mind the direction. A payment the corporation makes for you, if it is a loan, goes in "loans to shareholders" (Schedule L, line 7 of Form 1120-S); see loans to shareholders on the balance sheet. "Loans from shareholders" (line 19) is money you lent the corporation, and it can give you debt basis, which can let you deduct losses beyond your stock basis (Form 7203 instructions). Booking the corporation's payment there reverses the story.

If you did lend the corporation money earlier, a payment for you can instead repay that loan. It goes on Schedule K, line 16e and your K-1, needs the loan record, and can produce gain where debt basis was reduced (Form 1120-S instructions; Form 7203 instructions). See shareholder loans to an S corporation.

How is a distribution booked, and what does it do to basis, Schedule K-1, Schedule L and Schedule M-2?

A distribution is booked against equity, not expense. Its nondividend part lowers the owner's stock basis and is reported on Schedule K line 16d and the owner's K-1. If the corporation still has earnings and profits from a C corporation year, part can instead be a dividend: Schedule K line 17c and Form 1099-DIV, not the K-1, with no basis reduction (section 1368(c); instructions). The entry debits shareholder distributions and credits cash or the card payable. If the payment was first coded to an expense, debit distributions and credit that expense account.

The owner files Form 7203 with the return for any year a nondividend distribution is received, even one basis fully covers (Form 7203 instructions); see S corporation shareholder basis. For the gain test, the year's income and other basis increases count first, but the year's nondeductible expenses, losses and deductions count only after the distribution (section 1368(d); Form 7203 instructions). Earnings and profits change the order; the excess-of-basis guide below covers it.

If a filed return deducted a personal item that is not wages, the deduction generally has to come out. Ordinary income rises, flows through to the owner and raises basis before the distribution lowers it. That change may reach the Form 1120-S and the owner's return. For the entries and a balance sheet that will not tie, see recording S corporation distributions. For distributions above basis, see the excess-of-basis guide.

What if only one owner took the personal spending?

A payment that only one of several owners received, and the others did not match, raises the equal-rights question under the one-class-of-stock rule. An S corporation may have one class of stock, meaning identical rights to distribution and liquidation proceeds. The test looks at the governing provisions: the charter, bylaws, state law and binding agreements. Actual, constructive or deemed distributions that differ in timing or amount are given appropriate tax effect (26 CFR 1.1361-1(l)(2)).

The regulations treat a timing difference between equal owners, excess pay to one owner and a below-market loan to one owner as not creating a second class of stock (26 CFR 1.1361-1(l)(2)(vi), Examples 2, 3 and 5). So wages or a real loan to one owner raise a different question from a distribution to one owner. If the governing provisions give every share identical rights, the IRS says disproportionate distributions do not end the S election, though they still get tax effect (Rev. Proc. 2022-19, section 3.02). Whether the others are owed a matching amount depends on the governing provisions. Record it, then settle the fix with a preparer; see unequal S corporation distributions.

How do I stop it: separate cards, an accountable plan, a reimbursement routine?

Keep the corporation's money and the owner's money apart, and give every owner payment a regular route. Steps:

1. Use separate accounts and cards, and no personal charges on the corporation's.
2. Pay the owner's reasonable pay through payroll. Make distributions on a schedule, in proportion to shares.
3. Repay the owner for real business costs the owner paid personally through an accountable plan; see reimbursing owner expenses.
4. Review the statements monthly. Label a personal charge when it posts, and decide its treatment before the next close.

What if it went on for years, or the S corporation has no payroll?

Years of personal spending beside little or no payroll is where the reasonable-pay rule applies first, and the IRS can reclassify the payments as wages (IRS). The books, the payroll returns and the owner's basis then have to be redone year by year.

Work in this order:

1. Stop new personal charges.
2. For each year, list the personal items and give each a label.
3. Compare what the owner was paid with reasonable pay for the work, year by year.
4. Recompute stock basis by year, so a distribution above basis shows up as gain.
5. List what was filed: the Form 1120-S and K-1s, Forms 941 and W-2s, and the owner's returns. Decide which need correcting.

Before you move money back into the corporation, settle the label. How a later deposit is treated depends on what the original payment was and on the paperwork, and it changes the books and basis.

The accuracy-related penalty is 20% of the part of a return's underpayment attributable to negligence or a substantial understatement of income tax (IRS). If payments are reclassified as wages, the corporation can also owe the employment tax, with failure-to-deposit penalties that are a percentage of the unpaid deposit (IRS). The IRS manual for examiners says reduced section 3509 rates could apply to an officer paid only through distributions, loans or personal expenses with no W-2, unless there was intentional disregard, but not where some W-2 wages were reported and more is recharacterized as wages (IRM 4.23.8.5.2.1). A responsible person who willfully fails to collect or pay over withheld tax can also owe the trust fund recovery penalty personally (section 6672); the manual says it does not apply to an assessment made wholly at section 3509 rates. Collection generally runs 10 years from assessment; see trust fund recovery penalty. A multi-year cleanup touches the books, payroll returns and basis together; see S corporation catch-up books and bookkeeping help.

Example

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

A sole owner's family bills

A single-owner S corporation with no earnings and profits from a C corporation year pays US$9,000 of family medical bills and a vacation from the business account. The owner already draws reasonable pay through payroll, and there is no loan paperwork. The US$9,000 is personal. With no wage treatment, it is generally a distribution: no deduction, and US$9,000 on line 16d and in box 16, code D. If the owner's stock basis was US$30,000 before this item and nothing else changed, it falls to US$21,000.

Had the bookkeeper coded the payment to "office expenses", ordinary income was US$9,000 too low. Fixing it raises the owner's K-1 income, and basis before the distribution, by US$9,000.

The company pays the owner's estimated tax

An S corporation sends US$15,000 of the owner's federal estimated tax from the company account. The tax is the owner's own, so the corporation cannot deduct it as a tax. With no wage treatment and no documented loan, it is a distribution of US$15,000. If the owner has no payroll that year, the wage question comes first. Treated as wages instead, the US$15,000 would go through payroll, with withholding, payroll tax and a W-2; the distribution label does none of that. A state pass-through entity tax paid in the corporation's own name under an election is a different payment: the corporation's tax.

Two shareholders, one owner's bills

Two equal shareholders own an S corporation. It pays US$20,000 of one owner's personal bills. If it is a distribution, it went to one owner only. If the shares carry equal rights under the governing documents, the other owner may be owed a matching US$20,000, or the payment may need another treatment. Which one is a documented decision with its own tax effects. That, with the books, needs a professional; see bookkeeping help.

Different for you?

• A year-end review found personal charges and the labels are not clear: no payroll or thin payroll, several owners, several years, a stock basis near zero, or filed returns that used the old figures each change the answer. Sort the years with S corporation catch-up books, and see bookkeeping help for the books, payroll and basis behind each label.
• You paid corporate costs yourself, and the corporation never repaid you: see S corporation expenses never reimbursed and reimbursing owner expenses.
• Employees and owners share company cards: use personal charges on company cards.
• You never ran payroll for yourself: start with S corporation payroll never run.
• You want the money treated as a loan: read borrowing from your own corporation.
• You took more than your basis: see distributions in excess of basis and S corporation shareholder basis.
• Other shareholders did not get matching amounts: see unequal S corporation distributions.
• Your business is a sole proprietorship, an LLC taxed as one, or a C corporation: see personal expenses paid from the business account, fixing commingled business and personal funds or C corporation paying owner expenses.