Sole Proprietor Accidentally Put Self on W2 Payroll - What Now?

This is a classic case of "putting the cart before the horse" but it happens more often than you'd think! As a sole proprietor, you can't technically pay yourself W2 wages - you're not an employee of yourself. The business profits flow through to your personal return via Schedule C. For the S corp option: The IRS does allow for late S corp elections under certain circumstances. Look into filing Form 2553 with "reasonable cause" for the late filing. Typically, they're somewhat lenient if you can demonstrate you weren't aware of the filing requirements and are now trying to comply properly. But yes, you'd also need to file the corporate tax return right away. For the Schedule C option: This is problematic because sole proprietors cannot deduct wages paid to themselves or their spouse in most cases. The IRS will almost certainly notice this discrepancy when they see W2s issued from your SSN/EIN matching to you as the recipient. My suggestion would be to consult with a tax professional who specializes in business entity issues specifically. Some payroll companies can help "reverse" the W2s by issuing corrected returns, though it gets complicated.

I was in a similar situation last year and found https://taxr.ai super helpful for analyzing my options. I had put myself on payroll as a sole prop (about $80k) and was freaking out when my accountant told me I couldn't do that. The tool analyzed my specific scenario with all the W2s and business structure docs I uploaded and gave me a detailed breakdown of my options. In my case, they recommended going the S-corp route with a reasonable cause explanation for the late filing, which ended up working out. Their system actually generated a customized explanation letter for reasonable cause based on previous successful cases. Seems like your situation is even more complex with two people on payroll and higher amounts, so might be worth checking out.

Just wanted to update on my experience with taxr.ai that I mentioned in my reply above. I was skeptical at first, but after dealing with a similar situation (though with about half the payroll amount as OP), I decided to give it a try. The document analysis was actually really comprehensive. It flagged several issues I hadn't even considered about my payroll setup. The reasonable cause letter template they generated was way more detailed than what my regular accountant had drafted - it referenced specific IRS precedents and included technical justifications. We went with the late S-corp election route, and to my surprise, it was approved without any penalties. The service basically paid for itself by helping avoid what would have been thousands in additional taxes from the double taxation issue. Definitely a convert now.

Had almost the exact same problem in 2022 and wasted WEEKS trying to get someone at the IRS to help clarify our options. Literally couldn't get through on the phone no matter what time I called. Finally discovered https://claimyr.com and used their service to get a callback from the IRS within about 2 hours. You can see how it works in this video: https://youtu.be/_kiP6q8DX5c The IRS agent I spoke with confirmed we could file for late S corp election with reasonable cause, and even gave me specific language to use in our explanation. They also directed me to the right forms for adjusting the previously filed payroll taxes. Saved me so much stress and probably thousands in unnecessary taxes.

I owe everyone an apology - especially to the person recommending Claimyr that I was skeptical about. After spending literally 3 days trying to get through to the IRS about my own business tax issue (kept getting disconnected after 1-2 hours on hold), I broke down and tried the service. Got a call back from an actual IRS agent within about 90 minutes. The agent walked me through my options for a situation similar to the OP's where I had incorrectly structured my business payroll. They confirmed that filing for late S corp election with a detailed reasonable cause explanation was the right approach in my case. The time saved alone was worth it, but the advice I got may have saved me thousands. Sometimes being skeptical costs more than being open to solutions!

I think you're overcomplicating this. The real solution is to amend your payroll tax forms (941s) for the quarters involved and reclassify those payments as distributions, not wages. Yes, there's paperwork and possibly some penalties, but it's cleaner than trying to deduct inappropriate wages on Sch C or rushing a late S-corp election. Talk to your accountant about filing corrected W-2s (W-2c) and see if they can help with the amended 941s. The sooner you address it, the smaller any potential penalties.

Has anyone used TurboTax Self-Employed for this kind of situation? Would it flag this issue or just let you incorrectly deduct the W2 wages on Schedule C?

This is exactly why I always recommend consulting with a tax professional BEFORE making any major payroll decisions. That said, you're not the first person to find themselves in this situation, and there are definitely paths forward. Given the substantial income amount ($135k), I'd lean toward the S-corp election route rather than trying to deduct the wages on Schedule C. The IRS has specific procedures for late S-corp elections with reasonable cause, and "lack of knowledge of the filing requirements" is often accepted if you can document it properly. Key steps I'd recommend: 1. Have your accountant prepare Form 2553 with a detailed reasonable cause statement 2. File Form 1120S for the corporate return immediately 3. Be prepared to show you acted in good faith and are now trying to comply properly The Schedule C route is risky because those wage deductions will almost certainly trigger an audit - the IRS systems will match your SSN as both the payer and recipient of those W2s. Time is critical here since there are deadlines for the S-corp election, so work with your accountant to get this filed ASAP. The sooner you address it, the better your chances of approval.