$0 W-2 wages deferred $9,000

[jsample]

We have a client whose business was taxed as a sole proprietor until 12/31/2017.  Effective 1/1/2018 he elected to become an S-Corp.  The owner was under the impression that he could defer like he was still self-employed, and then max-out after the year end.  He also assumed that his shareholder dividend could be used as compensation.  His 2018 W-2 wages were $0.

I’m not sure how he actually deferred throughout the year without compensation, I think he took what he considered draws and contributed them into the plan.

Now we have a plan where an owner with $0 W-2 wages thinks that he deferred $9,000.

How would this “deferral” be corrected?

·         Should it be returned to the owner as a 415 excess?  This would generate a 1099.  This was my original thought for correction, but how could someone get money returned when technically they didn’t have it to defer to begin with?

·         Should the money revert back into the company somehow, as an operational error (possibly failure to follow the terms of the plan, with no 1099 issued to the owner)?

As a side question, I thought an owner had to take reasonable compensation in an S-Corporation.

[spiritrider]

Yup, a huge red flag. Even more so with the new 199A Qualified Business Income (QBI) deduction. They will be looking for S-Corps with excessive distributions, because that is what an S-Corps's QBI is based on.

Not to mention that if the client in not a specified service trade or business and taxable income is >= the QBI phase range. Their QBI will be limited to 50% of their W-2 wages. No W-2 wages, no QBI.

There will be problems with late FICA and FUTA payments and late W-2, but the failure to pay W-2 wages might fixable. It is a lot better than being determined to have unreasonably low compensation. The penalty is 100% of unpaid FICA.

This not to say that the failure to have wages to defer from is correctable retroactively. It is two separate issues.

The client needs immediate intervention by a knowledgeable CPA, if not tax lawyer or enrolled agent.

[austin3515]

I don't think I necessarily agree.  To me he has ZERO w-2 wages. Because he's an S-Corp he has zero eligible comp.  The $9,000 is ineligible and he needs to have 100% returned as a mistake of fact.

And he needs a new CPA if that CPA did not mention the need for W-2 wages when he/she completely changed the lay of the land.

[Bird]

I think a question that needs to be asked is if there are any employees.  And another is, where did the money come from?  

I'd look at it like this - he absolutely positively did not defer anything.  There were no wages from which to make a deferral.

So you have a "deposit" (from his personal bank account?  from his corporation?) that looks like an employer contribution.

If he has no employees then there is definitely no issue with returning it.  Probably as a mistake of fact (bad estimate of wages to support such an employer contribution).  If he has employees...there's a case to be made that it was an employer contribution that should be allocated.  A pretty strong case.  

[austin3515]

I dunno I think the circumstances should be relevant. How was it accounted for. If a daily val platform was allocated to his 401k account. If it was FBO was it deposited to his own personal account.

Doesn't seem to fair that someone should be beguiled out of $9,000 due to a transition period expecially when, depsite lack of any good advice, it is really a very understandable mistake.

[Bird]

Definitely not fair but that's not a criterion for correction.  Adviser error isn't either.  I'm not saying I wouldn't let him pull it out but it calls for a heart to heart talk about who is liable in the event it blows up.

To flesh it out more, if the money came from his own pocket or the old sole prop, then that's a better scenario; those contributions probably aren't allowable under any circumstances.  If it came from the corp, that would make a clear case for an employer contribution.  FWIW.

[jsample]

Thank you, yes there are eligible employees.  Money was contributed from corporation, although the owner thought he was simply taking draws and putting into plan, as he did in prior years.  He certainly was not trying to beat the system or take advantage of anything, owner just did not know the difference that occurred after becoming taxed as an s-corp.   Accountant now wants to pay owner as a consultant, for 2018, generating self employment income to substantiate the contribution. 

[austin3515]

5 minutes ago, jsample said:

Thank you, yes there are eligible employees.  Money was contributed from corporation, although the owner thought he was simply taking draws and putting into plan, as he did in prior years.  He certainly was not trying to beat the system or take advantage of anything, owner just did not know the difference that occurred after becoming taxed as an s-corp.   Accountant now wants to pay owner as a consultant, for 2018, generating self employment income to substantiate the contribution. 

Creative I guess, but sorry Charlie, no cigar.  It is doubtful that the "Schedule C" adopted the Plan.  So it it is still not eligible. 

And that solution would be classified as trying to beat the system :) 

[Bird]

 

16 hours ago, austin3515 said:

It is doubtful that the "Schedule C" adopted the Plan.

Actually I think the new question is - did the corporation adopt the plan?  I'd bet, based on the general tenor of this case, that it's still the sole proprietor's plan.  Which really flips the script.  

[jsample]

The business originally operated as an LLC, electing to be taxed as a sole proprietorship.  In 2018, the LLC elected to be taxed as an S-Corporation.  We kept the Form of Business unchanged on the adoption agreement; Limited Liability Company.

[austin3515]

Well thats good but its still unsupportable to write a check today and call it 2018 comp.

And I go back to my original statement which is based on what you just said the sole proprietorship has not adopted the plan anyway.  So that's 2 very compelling reasons it won't work.

[Bird]

Based on the latest facts, I pretty much agree with Austin.  The good news is that the document covers the entity on an ongoing basis.  The bad news is the rest of the facts are ugly.

As far as the accountant doing whatever he's doing to create 2018 income for the sole proprietor, I guess that's his call and his problem.  But then you still have the issue of the sole prop not adopting the plan.  There's a (flimsy?) argument that it could be done by 3/15 retro to the prior year, as an amendment that increases benefits.  But it's 3/19...

Might be a case where it's best not to make the client's problem your problem.  (Of course it will probably get twisted around and blamed on you somehow.)

[jsample]

Thank you very much for all of your insights.

[card]

On 3/12/2019 at 4:11 PM, jsample said:

How would this “deferral” be corrected?

As to your original question, FWIW the IRS has an FAQ here that includes the following:

"If you’ve made contributions to a 401(k) plan based on a shareholder’s S corporation’s distributions, find out how you can correct this mistake."