No Schedule C current year

Unbelievable, but accountant asking for our opinion here.

Sole proprietor sponsors a DB plan, compensation obviously Schedule C. Plan is valued beginning of year, ie 1/1/2020 with Schedule C based on prior year.

The client has an auto withdrawal from his personal account deposited to the plan during the year.

He had $0 Schedule C for 2020, but since valuation is beginning of year and using prior year Schedule C, we backed into the contribution and showed on Schedule SB as well as form 5500-EZ.

He filed his 1040 in March, no Schedule C; but did receive compensation, included in income for 2020, which the accountant showed on the 1040 and claimed a deduction for the contribution

He gets a tax bill from the IRS for $29,000; they claim since he had no Schedule C, he is not entitled to a deduction.

Since he made the contribution, and is shown on the brokerage statements for each month, in order to reconcile included the contribution, since shown on the statements, and was included on Schedule SB and the 5500s.

Since minimum funding and deduction are separate matters, we are thinking of withdrawing  just the amount of taxes owed, show as an in-service distribution (client over age 62), give a 1099-R, deposit into his business account; pay the fine; but more importantly, stop the auto withdrawals and make absolutely sure the client that is paying him gives him a Schedule C in the future.

Thoughts. besides advising to find a new accountant?

48 minutes ago, thepensionmaven said:

He filed his 1040 in March, no Schedule C; but did receive compensation, included in income for 2020, which the accountant showed on the 1040 and claimed a deduction for the contribution

You mean he had W-2 comp?  Not sure what kind of comp he received.

49 minutes ago, thepensionmaven said:

and make absolutely sure the client that is paying him gives him a Schedule C in the future.

You mean gives him a 1099 so he can file a Schedule C?  If he received money and it was not W-2 income, then it should have been reported on a Schedule C whether he got a 1099 or not.

Lets break it to separate points ignoring W2, since there is no information how W2 is related to his sole proprietorship:

1. Since you supported contribution amount with your BOY valuation, Schedule SB and the 5500 are correct to show contributions.
2. Since he had no Schedule C income, he could not deduct it.
3. So he needs to file the amended tax return that will show no contribution, which will result in additional tax with interest and possible penalties. This has nothing to do with his business account.
4. If he has personal funds to pay these additional taxes, you will not need any in-service distribution.
5. Having in-service distribution to pay taxes is the worst case scenario. The money were not deducted, but you will pay income taxes  on in-service distribution.
6. And yes, any sole-proprietor should not make any DB contributions during the plan year, unless he is 200% certain, his net Schedule C income will cover the amount.