This really should be filed under “Things Tax Preparers DIDN’T Say”.
And again it’s about S-corporation compensation.
SCENARIO:
S-corporation owner hasn’t been paying himself a salary despite having large corporate net income, and despite taking large withdrawals of money from the corporation. Those withdrawals had always been called “shareholder distributions.”
On the owner’s personal return, all of the corporate net income was reported as ordinary income. He also makes contributions into an IRA.
PROBLEM:
The salary issue is the obvious problem here. But it’s not the only problem.
Normally, contributions into a traditional (pre-tax) IRA are deductible on your personal tax return. But that’s only if you have “earned income.”
Pass-through income from an S-corp is not considered earned income.
He had nothing else happening on his tax return other than the S-corp and IRA parts.
Because he had no earned income, his deposits into the IRA were not deductible.
Worse yet, because he had no earned income, he also owed an excise tax on those IRA contributions because he made “excess contributions” into an IRA.
So to recap: he was working in his S-corp “earning” all of the income the corporation generated. He was reporting this income as ordinary income on his personal tax return. But because he wasn’t paying himself a salary, he had no “earned income” under tax law, so he was reporting all of this income on his tax return, not getting the deductions for the IRA contributions, and paying an excise tax on the IRA contributions as well!
And his accountant had never said a word to him about the need to pay himself a salary or the issue with the IRA.
Things like this don’t shock me anymore.
It would be one thing if the accountant had brought these issues up but the client decided to just keep doing things the same way (this does happen).
But in this case the conversation had never, ever happened.
And since I’m on a roll, I’ll continue with my rant even though the word count on this post indicates I should stop.
HERE’S A BONUS PROBLEM:
The bonus problem is: the propensity that we tax folks have for saying the following: “Oh well. The client gave us financials that showed $0 of compensation. We prepared the return based on that information. Our engagement letter states that we will prepare the return based on the information the client provides, without review or audit. If tax advising is desired it will be given under a separate engagement agreement. If the client doesn’t ask for help on the S-corp salary or IRA issue, it’s not our problem.”
Sure, that’s what our insurance providers make us say in our engagement letters. But I don’t think that absolves us from at least MENTIONING the salary issue, and bringing the IRA issue to the client’s attention.
But I suppose this is a topic best addressed in its own blog post.
Image courtesy of Stuart Miles / freedigitalphotos.net