Schedule C owner paid himself W-2 salaries - what's the best way to fix this mistake?

12 Thanks for the info. Would there be any penalties for the client in this situation? Also, what about the Social Security and Medicare taxes that were already paid through the payroll process? Would those be lost or could they be recovered somehow?

7 Regarding penalties, the IRS generally doesn't impose penalties in this situation if it was a genuine misunderstanding, especially for small businesses. However, the client should be prepared to explain the situation if questioned. As for the Social Security and Medicare taxes already paid, unfortunately those are typically not recoverable in this scenario. The employer portion of those payroll taxes essentially becomes an additional "cost of doing business" that was unnecessarily paid. The employee portion would have been paid anyway through self-employment tax, though the calculation would have been different. Going forward, proper tax planning can help optimize the tax situation.

8 How exactly does that work? Does it just give generic advice or does it actually look at your specific documents? I'm dealing with something similar but with a rental property LLC where I accidentally paid myself as an employee.

19 Sounds like a sales pitch to me. No AI can replace a good CPA who understands the nuances of business structures and tax law. Did this "AI" file your returns for you too or just give you advice that you still had to implement?

15 The AI actually reviews your specific documents and situation - it's not just generic advice. You upload your tax documents, payroll records, and answer some questions about your business structure. It then analyzes everything and gives you tailored recommendations for your exact situation. For your rental property LLC situation, it would analyze whether you need to reclassify those payments as distributions, what forms you need to correct, and whether you qualify for any safe harbor provisions. I found it much more affordable than paying my accountant for hours of research on an unusual situation.

21 Wait, how does this actually work? Is it just a fancy way to get in the phone queue or what? The IRS phone system is notoriously terrible but I'm skeptical anything can actually get you through faster.

19 Yeah right. So you're saying this service somehow magically jumps you ahead in the IRS queue? Sounds like snake oil to me. The IRS doesn't give priority access to anyone unless you're going through a Taxpayer Advocate.

9 It's not actually magic or queue jumping. The service uses an automated system that handles the hold time for you. Basically, you tell them who you need to reach at the IRS, and their system keeps dialing and navigating the phone menus until it gets through. Then it calls you back and connects you when an actual human at the IRS picks up. You don't waste hours listening to hold music. It doesn't give you special priority in the queue - it just handles the horrible waiting process so you don't have to sit there for hours. For specific tax issues like this Schedule C/W-2 problem, getting direct guidance from the IRS can prevent making things worse.

5 At what profit level do you typically recommend clients make the switch to S Corp? I've heard different thresholds from different accountants.

3 The threshold where S Corp makes sense varies based on several factors, but generally I start running the numbers when a business consistently nets around $60,000+ annually. Below that level, the self-employment tax savings typically don't outweigh the additional costs of maintaining an S Corp (separate payroll processing, more complex tax filing, potential state fees, etc.). Every situation is different though - some businesses have other reasons for wanting S Corp status beyond just tax savings, such as liability protection considerations or bringing on investors.

22 That's a good point. I think you'd still need to report the W-2 income on your personal return since it's tied to your SSN, but the payroll tax situation gets messy. This is why some accountants recommend just filing correctly going forward rather than trying to fix the past.

16 You're absolutely right. If you don't reconcile the 941s/W-2s with how you're treating the payments on the Schedule C, you're asking for a notice from the IRS. The proper handling is to report the income from the W-2 on the personal return (since it's been reported under their SSN), but on the Schedule C, you'd add back those wages as non-deductible "wages to owner" in the other expenses section with a clear description. This creates a clear audit trail showing you're not double-dipping while acknowledging the mistake.

This is really helpful advice, especially the part about creating a separate line item for "Owner wages (non-deductible)" - that seems like the cleanest way to handle the documentation issue that was raised earlier. Quick question though - when you say "attach a statement to the return explaining the situation," are you talking about just a simple letter, or is there a specific IRS form or format that works best for this type of disclosure? I want to make sure I'm covering all the bases if I run into this situation with a client. Also, do you typically recommend the client get professional liability insurance or take any other precautions when dealing with these kinds of correction situations?

For the disclosure statement, I typically use a simple business letter on firm letterhead that gets attached to the return. It doesn't need to be overly complex - just something like "The taxpayer paid wages to himself during 2024 under the mistaken belief that an S-Corporation election was in effect. Upon discovering no election was filed, wages are being treated as non-deductible owner distributions going forward." Keep it factual and brief - you don't want to over-explain and create more questions than necessary. The IRS appreciates transparency but not lengthy justifications. Regarding professional liability insurance, that's always a good idea for any tax preparer, but especially important when handling correction situations like this. I'd also recommend documenting everything thoroughly in your client file - emails, notes from conversations, copies of the original incorrect filings, etc. This protects both you and the client if there are any future inquiries. One more tip: if the business has employees other than the owner, make sure those legitimate employee wages are still properly deducted. Only the owner's wages should be treated as non-deductible.

Thanks for sharing your real-world experience with this approach! It's really reassuring to hear that the transparency method worked without triggering any IRS issues. As someone new to handling these types of business structure mistakes, I was worried about potential audit flags, but your outcome gives me confidence in recommending this path to clients. One follow-up question - did you end up making an S-Corp election for this year, or did you decide to stay with Schedule C? I'm curious how you evaluated whether the administrative burden was worth it for your specific situation. Also appreciate you mentioning that this mistake is more common than people think. It definitely makes me feel better about advising clients through similar situations knowing that the IRS has reasonable expectations about small business owner confusion around entity elections.