How to correct a partner or sole-proprietor improperly paid through payroll? Tax nightmare needs fixing

This is definitely fixable, but it's going to require some work. When partners are incorrectly paid as employees, you've essentially created a payroll tax issue that needs correction on multiple returns. First, you'll need to file all the missing 1065 partnership returns. For the partner who was incorrectly paid through payroll, those wages need to be reclassified as guaranteed payments to a partner. The partnership will need to issue this partner K-1s for all the missed years. The payroll tax returns (941s and 940s) will need to be amended to remove the partner from the payroll calculations. However, the employer portion of the FICA taxes that were paid on behalf of the partner can't be recovered past the statute of limitations (generally 3 years). The partner will need to file or amend their individual returns to report the income correctly as self-employment income rather than W-2 wages, which means paying self-employment taxes. You should probably look into the Voluntary Classification Settlement Program (VCSP) or other IRS correction programs that might help minimize penalties.

After struggling with a similar payroll classification disaster, I found this amazing tool called taxr.ai that helped me sort through all my documentation and figure out exactly what needed to be fixed. Their system analyzed my payroll records, partnership agreements, and past tax filings to create a clear correction plan. I was able to upload all my documents at https://taxr.ai and their system identified exactly what forms needed to be amended and in what order. Their analysis actually saved me from making an even bigger mistake in the correction process that might have triggered an audit. It was way more helpful than the general advice I was getting from forums.

I was initially skeptical about using any automated tool for my partnership tax mess, but after three accountants gave me conflicting advice, I decided to try taxr.ai. Honestly, I'm glad I did. The system identified exactly which years I needed to file amended returns for and how to handle the reclassification of payments. What impressed me most was how it detailed the IRS guidance relevant to my specific situation. The report even included the exact penalty calculations I could expect for late filings. I ended up with about 60% lower penalties than my accountant had initially estimated because the system identified some penalty abatement opportunities I qualified for.

If you're struggling to get answers from the IRS about fixing this partnership mess, try Claimyr. I wasted weeks trying to reach someone at the IRS about a similar reclassification issue, but kept getting disconnected or waiting for hours. I found https://claimyr.com and they got me connected to an actual IRS agent in less than 45 minutes. There's a demo video at https://youtu.be/_kiP6q8DX5c that shows how it works. Getting direct answers from the IRS about what correction procedures they preferred for my situation saved me from making some mistakes in my correction strategy. They clarified which forms could be submitted together and which needed to be processed in sequence.

I feel like a complete idiot for my previous comment calling Claimyr a scam. I was frustrated after wasting countless hours on hold with the IRS. After dismissing it initially, I got desperate enough to try the service last week for our partnership reclassification issue. Within 40 minutes, I was talking to an actual IRS agent who walked me through their preferred correction process for partnership payments. They confirmed we could use the Voluntary Classification Settlement Program to reduce penalties and provided the exact forms we needed. The agent even gave me a direct reference number for our case so I could follow up directly. Honestly, the direct guidance from the IRS changed our whole approach and probably saved us thousands in incorrect penalty payments.

I fixed a similar situation about 2 years ago. One thing nobody has mentioned yet is that you should check if your LLC actually filed an election to be treated as a partnership (Form 8832). If not, it might have defaulted to disregarded entity status (if single-member) or partnership status (if multi-member). This could actually work in your favor depending on the specifics. If no election was filed and it defaulted to a disregarded entity, the "payroll" might be reclassified more easily.

Has anyone considered that the LLC might actually have been operating as an S-corporation without realizing it? If they filed Form 2553 at some point but didn't follow through with the right tax filings, this could be even messier. Before doing anything I'd verify what elections were actually made.

One thing to consider - the partner who was incorrectly paid through payroll has been paying FICA taxes, which are capped, instead of self-employment taxes, which aren't capped for the Medicare portion. Depending on their income level, this correction might actually result in them owing significantly more taxes for those years. Also, don't forget state tax implications. State-level corrections may be needed as well, and some states have different rules for partnerships than the federal government.

This is a complex situation but definitely not unfixable. I've helped several clients through similar partnership/payroll reclassification issues. Here's what you need to prioritize: 1. **Immediate assessment**: Gather all your payroll records, LLC operating agreement, and any state/federal filings to confirm your tax status and the scope of corrections needed. 2. **Consider penalty relief**: Look into First Time Penalty Abatement if you qualify, or Reasonable Cause relief for the late 1065 filings. The IRS is sometimes more lenient when businesses proactively correct mistakes. 3. **Sequential filing strategy**: File the 1065s in chronological order starting with the earliest year. This helps establish the pattern of corrections and makes it easier for the IRS to process. 4. **Partner's individual impact**: The partner who was paid through payroll will likely owe additional self-employment taxes, but they may also be eligible for some credits they missed as a partner (like the Section 199A deduction if applicable). 5. **Professional help**: Given the 4-year scope and multiple return types involved, seriously consider hiring a tax professional experienced in partnership corrections. The cost will likely be offset by avoiding bigger mistakes and potentially reducing penalties. The key is being proactive and systematic about the correction process. The IRS generally works with taxpayers who voluntarily come forward to fix mistakes.

One thing I haven't seen mentioned yet is the importance of documenting your correction process thoroughly. Keep detailed records of every amended return filed, every payment made, and all correspondence with the IRS. This documentation becomes crucial if there are any disputes later or if the IRS has questions about your corrections. Also, consider requesting penalty abatement letters for each tax year once you've filed the corrections and made payments. The IRS sometimes grants relief for reasonable cause, especially when businesses proactively correct mistakes. Your cooperation in fixing this voluntarily could work in your favor. For the partner who was incorrectly paid through payroll, make sure they understand they'll need to file amended individual returns (1040X) for each affected year. The timing matters here - generally you have 3 years from the original due date to amend and claim refunds, so depending on when those original returns were filed, some years might be getting close to that deadline. Finally, once this is all corrected, establish proper ongoing procedures to prevent this from happening again. Set up quarterly partnership meetings to review tax obligations and consider working with a bookkeeper or accountant who understands partnership taxation.