Form 1120-S Balance Sheet (Schedule L) Won't Balance: Fixes

Why won't the Form 1120-S balance sheet (Schedule L) balance?

Schedule L is the corporation's balance sheet per its books, and the instructions say it should agree with the corporation's books and records. It balances when total assets (line 15) equal total liabilities and shareholders' equity (line 27), in the beginning-of-year total column (b) and the end-of-year total column (d) of the form. When the form does not balance, the cause is usually the books, or how they were carried onto the form. Forcing the form to balance fixes neither. Line numbers follow the latest published form; check them against your tax year's.

Check in this order:

Then read the size of the gap (bookkeeping arithmetic, not an IRS rule). A gap equal to one amount points to a one-sided entry or an account left off the form; twice an amount, to an entry posted to the wrong side; a multiple of nine, often to swapped digits.

A case is not simple when:

• The gap is more than rounding and cannot be traced to specific entries.
• Last year's closing balances do not match this year's opening balances.
• Last year's return may have been filed with a plug, an entry made only to force the totals to agree.
• The books cover more than one year and the bank accounts were never reconciled.
• A shareholder loan, distribution or personal payment cannot be tied to a document.
• The S election ended during the year. The instructions say the year-end balance sheet should generally agree with the books at the end of the C short year, or at the end of the S short year if the corporation made the section 1362(e)(3) election: a statement filed with the C short year's return, with the signed consent of everyone who was a shareholder during the S short year or on the first day of the C short year.

These can mean an earlier return needs correcting, not only this year's books.

Gather:

• Last year's filed Form 1120-S, including Schedules L, M-1 and M-2 and the K-1s
• The year-end trial balance for each year in question
• Bank and card reconciliations for every account
• The shareholder loan ledger and the distribution ledger
• Schedule L as the return software printed it, with its account map

Does an S corporation have to complete Schedule L at all?

Not if it answers Yes to Schedule B, question 11: total receipts and total assets at year end must each be under $250,000, and the form then says the corporation is not required to complete Schedules L and M-1. This page assumes the corporation completes Schedule L. For who must complete it, what counts as total receipts and how to produce one, see Schedule L balance sheet on a corporate return.

What is line 12 on Form 1120-S?

It depends on the page. On Schedule L, line 12 is land, net of any amortization. On page 1, line 12 is taxes and licenses, a deduction. On Schedule K, lines 12a to 12e are deductions passed through to shareholders, and Schedule B, question 12 asks about canceled or reduced non-shareholder debt (form). A balance sheet that will not balance concerns Schedule L, so read the schedule name before the line number.

Does the beginning-of-year column match last year's ending column?

Yes. Column (b) of this year's Schedule L should equal column (d) of last year's, line by line, because the start of one tax year is the end of the previous one. The Form 1120-S instructions for Schedule L do not state this rule. The instructions for corporations that file Schedule M-3 do: opening total assets generally must equal the prior year's closing, and each item that differs needs an attached statement. Other corporations are not given that exact rule, but both years' balance sheets come from the same books.

In a corporation's first year there is no earlier Schedule L; the opening column should agree with the books at the start of the year. For a business that existed before the election, see books after an S corporation election.

Put last year's filed column (d) beside this year's column (b) and mark every line that differs. The usual reasons:

• The books were restarted in a new file or new software, and opening balances were typed in from an old report. See opening balances after changing accountants and Opening Balance Equity.
• Entries were made after the books closed, or a closed year was edited, so the books no longer match the filed return.
• The new file switched between cash and accrual, which adds or removes receivables and payables at the start. The balance sheet follows the accounting method the books regularly use. A change in the method used for the return is a separate step that generally needs IRS approval, usually requested on Form 3115.

Before posting a fix, confirm that last year's filed Schedule L agreed with last year's books (see the last section on a plugged return). If it did, the usual fix is a dated entry on the first day of this year that moves each differing account to its filed balance, with the other side posted to opening retained earnings, not income or expense, so this year's income does not change. If it did not, settle the earlier return first; an opening entry would carry the error forward. Do not quietly edit a closed year. For the general method, see retained earnings that do not match last year's return.

What goes on each equity line of Schedule L?

Schedule L has five equity lines, and owner distributions are not one of them. Choosing between lines 22 and 23 is bookkeeping practice; the IRS instructions do not define them.

Distributions reduce equity in the books. On the return they appear on Schedule K, line 16d, and on each shareholder's K-1 (box 16, code D), not on Schedule L (instructions). Dividends paid from accumulated earnings and profits go instead on Schedule K, line 17c and Form 1099-DIV, not on the K-1. For the entries, see recording S corporation distributions.

Do retained earnings on Schedule L match the accumulated adjustments account?

Not necessarily. Retained earnings (Schedule L, line 24) is a book number, and a difference from the accumulated adjustments account (AAA; Schedule M-2, column (a)) is expected, so do not force them to agree. The AAA is a tax account that generally reflects the corporation's accumulated undistributed net income, under rules in the instructions.

What must tie is each account to its own prior year: retained earnings to last year's Schedule L, and the AAA to last year's Schedule M-2 closing balance. A break within either one needs a documented reason, such as a corrected return; otherwise suspect the books.

Retained earnings is also not stock basis. The IRS says tracking stock and debt basis is the shareholder's responsibility, not the corporation's. See S corporation shareholder basis.

Do loans from shareholders on Schedule L agree with the K-1 and the books?

Yes. Schedule L, line 19, loans from shareholders, generally should reconcile to the sum of the amounts on the K-1s. K-1 item I reports the debt the corporation owes directly to each shareholder at the start and end of the year. It leaves out debt where the shareholder is only a co-borrower or guarantor of corporate-level debt, and it leaves out intercompany debt.

Roll the ledger forward for each shareholder: opening balance, plus new loans, minus repayments, equals closing balance. Repayments also appear on Schedule K, line 16e, and on the K-1 (box 16, code E).

Loans go wrong in three ways:

• A shareholder's deposit was booked as sales, so line 19 is blank and income is overstated.
• A repayment was booked as an expense or as a distribution.
• A bank loan the shareholder only guaranteed was booked as a shareholder loan.

Line 7, loans to shareholders, runs the other way: money the corporation lent to an owner. See loans to shareholders on the balance sheet and shareholder loans to an S corporation.

Does net income per books agree with Schedule K and Schedule M-1?

Net income per books is line 1 of Schedule M-1, and the M-1 must end at the amount on Schedule K, line 18. The instructions say line 18 must equal Schedule M-1, line 8, or Schedule M-3, Part II, line 26, column (d). A corporation with total assets of $10,000,000 or more on the last day of the tax year files Schedule M-3 instead; the steps below describe Schedule M-1.

Two checks use the same book net income:

1. Retained earnings roll-forward. Closing retained earnings should equal opening retained earnings, plus net income per books, minus all distributions (the K-1 distributions plus any line 17c dividends, though line 16d values distributed appreciated property at fair market value, which the books may not), plus or minus any entry posted straight to equity. This is bookkeeping arithmetic, not an IRS formula.
2. Schedule M-1. Start at line 1, net income per books. Add the lines 2 and 3 items (for example book depreciation not deducted on the return, and non-deductible travel and entertainment). Subtract the lines 5 and 6 items (for example tax-exempt interest, and tax depreciation not charged to book income). The result, line 8, must equal Schedule K, line 18 (form).

Every difference between book income and line 18 must be a listed item. A leftover amount means an item is missing from Schedule M-1, or book income or return income is wrong. Page 1, item F, total assets, must also equal Schedule L, line 15, column (d), when Schedule L is required (instructions). For how the books feed the return, see books to the business tax return.

Which bookkeeping errors cause the gap?

Two problems look alike. A form that does not balance (line 15 differs from line 27) comes from a one-sided entry, an account left off the form or a mapping error (step 1 above). A form that balances but does not tie comes from a balanced entry in the wrong account. Only the last row below unbalances the form; the others break a tie.

Is it safe to force the balance with the adjustments to shareholders' equity line?

No. Line 25 is for equity adjustments such as the examples in the instructions, and a gap caused by a books error is not one of them. The instructions for line 25 give examples such as unrealized gains and losses on securities held "available for sale" and foreign currency translation adjustments. The form also asks for an attached statement.

A plug leaves the form and the books disagreeing:

• The balance sheet should agree with the books and records, and the books do not contain the plug.
• An officer signs the return under penalties of perjury, declaring that, to the best of their knowledge and belief, it is true, correct and complete.
• The plug can carry forward. If next year's opening column starts from the plugged number, the gap returns, and K-1 amounts built on the same error stay wrong until the error is found.

Retained earnings on line 24 is not a place to park the difference either. Find the entry instead.

What if last year's return was filed with a plug or different balances?

First find out what was filed. Compare last year's Schedule L, column (d), with the books' closing balances for that year. If they differ, last year's balance sheet did not agree with the books.

The instructions give one way to correct a filed return: file an amended Form 1120-S, check box H(4), and attach a statement with the line number of each amended item, the corrected amount or treatment and the reason. If K-1 information was wrong, an amended K-1 goes to each affected shareholder with it. A K-1 that shows incorrect information can draw a penalty of up to $340 per K-1 for an ordinary failure, unless there is reasonable cause (instructions).

The Form 1120-S instructions do not say whether an error confined to the balance sheet must be amended or may be explained on the next return. That call depends on the facts, including whether income, distributions, loans or K-1 amounts were also wrong. Settle it before filing the new year's return, so the opening column is consistent with whichever way it goes. See correcting a filed business return.

Example

These examples are illustrative, in US dollars.

Distributions booked as an expense

A one-owner S corporation's books show net income of US$88,000. The return shows income of US$100,000, and the K-1 shows a US$12,000 distribution that is not in the ledger. The owner took US$12,000 during the year and the bookkeeper coded it "owner expense". Books and return now disagree on income and on distributions by the same amount, and the retained earnings roll-forward (opening, plus net income per books, minus the K-1 distributions) is off by US$12,000. Schedule L still balances here; the error sits in income and distributions. If the payment was an owner distribution, the books would move the US$12,000 from expense to distributions. Net income per books becomes US$100,000, matching the return, and closing retained earnings do not change. If it was pay for work, it is wages, a payroll question to settle first.

Opening retained earnings are off by US$15,000

The books show beginning retained earnings of US$40,000. Last year's filed Schedule L, line 24, column (d), shows US$55,000. The books were moved to new software, and the opening balance was typed in from a report run before the preparer's year-end entries. The US$15,000 gap is traced through the final adjusting entries in last year's workpapers. If they explain it and last year's filed return agreed with the books, their net effect can be posted against opening retained earnings in a dated entry on the first day of this year, so the opening balances match what was filed. If they do not, or the filed return was built from the other figure, last year's balance sheet needs a second look before this return is filed.

A shareholder loan booked as sales

A shareholder deposits US$30,000 into the company account to cover a slow quarter, and the bookkeeper codes it as sales. Net income per books is overstated by US$30,000, Schedule L, line 19, shows no loan, while the loan note and the K-1 show US$30,000. If the deposit is a real loan, reclassify it from sales to loans from shareholders; if it was a capital contribution, it goes to paid-in capital instead. Because income was overstated, a return already filed on those books may need correcting.

Different for you?

• The gap is more than rounding, last year's closing balances do not match this year's opening balances, or last year's return was filed with a plug: whether the books need a clean-up or an earlier return needs correcting, and which years to rebuild before this return is filed, depends on your records. See corporate tax help.
• The books are months or years behind, or personal spending went through the company account: see S corporation catch-up books and bookkeeping help.
• The return is already filed and the error is in it: see correcting a filed business return.
• The due date arrives before the books tie: a late Form 1120-S, or one that leaves out required information, can cost the corporation $260 per shareholder for each month or part of a month, up to 12 months, even when no tax is due, unless there is reasonable cause (section 6699). An extension on Form 7004 has to be filed by the regular due date, March 15 for a calendar-year corporation. See an extension when the books are not ready.
• A shareholder lent money to the corporation, or the corporation lent to a shareholder: see shareholder loans to an S corporation and loans to shareholders on the balance sheet.
• Distributions may have exceeded basis: see distributions in excess of basis.
• You prepare the return yourself: see filing your own S corporation return.
• The corporation was a C corporation before: its earlier balance sheet is on Form 1120, not Form 1120-S. See switching a C corporation to an S corporation.