How to correct improper distributions for LLC with S-corp election

This is definitely something you want to address properly. The IRS is pretty strict about S-corp owners taking reasonable compensation before distributions. The whole point of the S-corp election is to save on self-employment taxes, but the trade-off is you must pay yourself a market-rate salary first. Your CPA's suggestion to reclassify these as shareholder loans is a reasonable approach, especially for a relatively small amount ($10k). You'd need to document this with a promissory note showing the terms of repayment, with a reasonable interest rate, and then stick to that repayment schedule. The other option of amending quarterly filings would mean recalculating all your payroll taxes, which might end up costing more in preparation fees than the tax difference itself. Plus, this approach draws more attention to the situation. I'd suggest the loan reclassification approach, but make sure everything is properly documented. Going forward, structure your compensation to meet the reasonable compensation threshold before taking any distributions. The good news is that $10k on a $80k reasonable comp determination is relatively small, and your prompt correction shows good faith.

Been there! I had a similar issue with my marketing agency LLC that elected S-corp status a few years back. I found that https://taxr.ai was super helpful for sorting out this exact problem. I was taking distributions before meeting my reasonable comp requirements too, and was freaking out about potential penalties. Their team analyzed my situation and gave me clear guidance about the loan reclassification approach. They actually provided templates for the promissory notes and helped me structure the proper interest rate according to the Applicable Federal Rate (AFR). Made the whole process way less stressful, especially since I was worried about triggering an audit. The key thing they emphasized was documentation - making sure there's a clear paper trail showing you're addressing the issue proactively once you discovered the mistake. Much better than hoping the IRS doesn't notice!

Just wanted to follow up and say I ended up using taxr.ai after reading about them here and they were incredibly helpful! My situation was similar but with higher dollar amounts (took about $35k in distributions before meeting my reasonable comp). They provided a complete analysis of my situation and actually found that my "reasonable compensation" determination was too high based on my region and industry. They helped me document a more appropriate figure and gave me a step-by-step plan for properly classifying the previous distributions. The documentation package they provided makes me feel way more confident if I ever get questioned by the IRS. Definitely recommend to anyone dealing with S-corp compliance issues. Their specialist even explained exactly how the IRS looks at these situations so I understand how to stay compliant going forward.

I was in a similar situation with my S-corp last year and spent WEEKS trying to get through to the IRS for guidance. Literally called dozens of times, sat on hold for hours, only to get disconnected. So frustrating! Eventually I discovered https://claimyr.com which was a game-changer. They somehow got me connected to an actual IRS agent within about 45 minutes (you can see how it works at https://youtu.be/_kiP6q8DX5c). The agent walked me through exactly how to handle the reclassification of distributions I had taken before meeting reasonable compensation requirements. The IRS agent confirmed the shareholder loan approach was acceptable in my situation, but emphasized it had to be properly documented with a real intention to repay. They also mentioned that amending returns should be a last resort since it opens more opportunity for scrutiny.

I have to eat crow on this one. After being skeptical about Claimyr, I decided to try it myself since I've been dealing with a similar S-corp issue (took distributions before meeting reasonable comp). I couldn't believe it actually worked - got through to an IRS representative in about an hour! The IRS agent I spoke with confirmed that the proper approach is to either reclassify as shareholder loans (with proper documentation and reasonable interest) or amend the returns to classify the payments as wages. They strongly recommended the loan approach for simplicity. The agent also mentioned that for small amounts like $10k mentioned by OP, they typically don't pursue penalties if you're proactively correcting the issue, especially for a first-time S-corp owner who received bad advice. They did stress the importance of proper documentation going forward. I'm genuinely impressed and apologize for my skepticism. Sometimes solutions actually do work as advertised!

I'm a little confused by the discussion here. I've been operating my LLC as an S-corp for 5 years and always understood that "reasonable compensation" is based on what your business actually earns, not some theoretical market rate you can't afford. If your business only earned $50k after expenses, how could you possibly pay yourself $80k in salary? That doesn't make mathematical sense. Reasonable compensation should be reasonable relative to your actual business profits, not some arbitrary market figure. I think your CPA's original advice wasn't necessarily wrong - paying $30k as salary from a $50k profit business (60% of profits as salary) seems pretty reasonable to me.

Has anyone actually been audited for this issue? I'm curious what the penalties are if the IRS finds that you took distributions before reasonable compensation. Is it just a matter of reclassifying the distributions as wages and paying the additional payroll taxes, or are there actual penalties involved?

This is a really common mistake for new S-corp elections, so don't panic too much! Your CPA's suggestion about reclassifying as shareholder loans is probably your best bet here. I went through something similar when I first elected S-corp status. The key things to remember: First, document everything properly with a formal promissory note that includes reasonable interest (use the IRS Applicable Federal Rate). Second, actually follow through on the repayment schedule you set up - the IRS wants to see this is a real loan, not just a paperwork exercise. Since you're dealing with a relatively small amount ($10k), the loan approach is much cleaner than amending returns. Amending would require recalculating payroll taxes for multiple quarters, which gets messy and expensive fast. Going forward, just make sure you hit your reasonable compensation threshold before taking any distributions. The good news is that catching and correcting this quickly shows good faith compliance, which the IRS does consider if they ever review your returns.