Understanding Paid in Capital and Return of Capital Process for 1120S - How Do I Document Non-Salary Distributions?

Thank you for that explanation! I'm still confused about one thing though - if I categorize the personal withdrawals as distributions on the K-1, won't that be a problem since we didn't take distributions proportionate to ownership? Only one shareholder took money out of the business account for personal use. Also, aren't distributions supposed to be after paying a reasonable salary? Since we didn't run payroll at all, will that cause issues with how distributions are reported?

You're right to be concerned about disproportionate distributions. S-Corps are required to make distributions based on ownership percentages. If you have equal owners but only one took money out, that's technically a disproportionate distribution which could potentially jeopardize your S election. As for the reasonable salary requirement, yes, the IRS expects active shareholders to receive reasonable compensation before taking distributions. Since you didn't run payroll at all last year, this is definitely problematic. The IRS could potentially recharacterize all distributions as wages subject to employment taxes. At this point, I would recommend considering the following approach: Document the transactions clearly in your internal records, report the distributions on the appropriate K-1, and consider catching up on the reasonable compensation issue going forward. You might also want to make equalizing distributions to the other shareholder to address the proportionality issue.

Does taxr.ai help with correcting past mistakes like this? I'm in a somewhat similar situation with my LLC (different tax structure I know) but I've been freaking out about how to untangle personal/business expenses from last year. Do they give you actual documentation you can show to the IRS if questioned?

I'm hesitant to use online services for complex tax situations. Can taxr.ai actually handle S-Corp specific issues like reasonable compensation requirements and disproportionate distributions? Those are pretty specialized tax areas.

Yes, they absolutely help with correcting past mistakes! They have a feature specifically for reconciling mixed personal/business transactions. You upload your statements, and their system helps identify and properly categorize everything. They also provide detailed reports you can use as supporting documentation. For S-Corp specific issues, they do address reasonable compensation and distribution problems. Their analysis includes specific guidance on how to handle disproportionate distributions and what documentation you need to maintain. They even helped me create a compensation plan for the current year to avoid future problems with the IRS.

How does this actually work? Do they just call the IRS for you? I don't understand how a third party service can get through the IRS phone system faster than I can doing it myself.

This sounds too good to be true. The IRS wait times have been ridiculous lately - I tried calling about my S-Corp issue last month and gave up after 2+ hours on hold. Are you sure the person you spoke with was actually from the IRS and not just some tax advisor from the service itself?

They don't call for you - they use technology to navigate the IRS phone system and wait in the queue on your behalf. When they reach a representative, you get a call back and are connected directly to the IRS agent. It's still the official IRS number and you're speaking with actual IRS employees. I had the same skepticism initially! But it's definitely legitimate - when you get connected, you're speaking directly with an IRS representative who verifies your identity and provides official guidance. The service just handles the waiting part so you don't have to sit on hold for hours. I confirmed this by asking the IRS agent specific questions about my account that only the IRS would know.

Would filing Form 4549 trigger an automatic audit though? I'm worried about opening a can of worms by voluntarily drawing attention to the payroll issue. And for the resolution authorizing return of capital - can I create that documentation now for transactions that already happened last year? What would that documentation need to include to be considered adequate?

Filing Form 4549 doesn't automatically trigger an audit. It's actually a way to proactively address an issue before the IRS finds it, which they often view favorably. You would include it with your return as a disclosure. For the resolution authorizing return of capital, yes, you can create it now (backdated) as long as it reflects what actually happened and your intention at the time. The documentation should include a corporate resolution signed by all shareholders stating the amount of paid-in capital being returned, to which shareholder(s), and acknowledging that all shareholders approved the transaction. Include specific dates and amounts that match your bank records.

An accountable plan is absolutely the way to go forward! I set one up for my S-Corp last year and it makes everything so much cleaner. You just need to document business purpose, keep receipts, and reimburse within a reasonable time. No more confusion about what's paid-in capital vs what's a business expense.

This is really helpful advice about the documentation requirements! I'm curious about the equalizing distribution approach you mentioned - if the non-active shareholder takes an equivalent distribution and then loans it back to the company, how should that loan be documented? Would it need to be a formal promissory note with interest terms, or can it be structured more informally? Also, are there any tax implications for the shareholder who receives the distribution just to loan it back immediately?

Great question about the loan documentation! If the non-active shareholder takes an equalizing distribution and loans it back, you'll definitely want formal documentation to avoid IRS scrutiny. A promissory note with reasonable interest terms (at least the applicable federal rate) is the safest approach. Without proper documentation, the IRS could treat it as a constructive distribution or contribution rather than a legitimate loan. Tax-wise, the shareholder will still need to report the distribution on their K-1 and pay taxes on it, even if they immediately loan the money back. The loan itself doesn't create a taxable event, but the initial distribution does. The company would then deduct interest payments to the shareholder as a business expense (and the shareholder reports the interest as income). One alternative to consider: instead of an equalizing distribution followed by a loan, you might document the unequal distribution as an advance against future distributions. This way, when future distributions are made, the non-active shareholder would receive more until things balance out. This approach maintains the S-Corp requirement for proportional distributions over time without creating the loan documentation complexity. Either way, having clear corporate resolutions documenting the shareholders' agreement on how to handle the disproportionate distributions will be crucial for defending your S election if questioned.

Thank you for sharing your experience with IRS scrutiny - this is exactly the kind of real-world perspective I was hoping to find! Your point about contemporaneous documentation is concerning since I'm essentially trying to reconstruct everything after the fact. I'm particularly interested in the spreadsheet approach you mentioned. When you say "supporting documentation," did you need original receipts for every transaction, or were bank statements and credit card statements sufficient for some expenses? I'm worried because some of my personal expenses for business purposes were small cash transactions where I may not have kept receipts. Also, regarding the formal agreement between shareholders for unequal distributions - did you create this agreement retroactively, or was it something you had in place beforehand? If it was created after the fact, how did you handle the timing issue with the IRS? I'm trying to understand if documenting our intention now (even though the transactions already happened) would be viewed favorably or suspiciously. Your mention of implementing proper payroll going forward is noted - I'm definitely planning to get that sorted for this year. Did the IRS give you any specific guidance on what constitutes "reasonable compensation" for your particular situation?

Great question about documentation requirements! In my experience, the IRS was surprisingly reasonable about supporting documentation. For larger expenses (over $75), they definitely wanted original receipts or invoices. For smaller transactions, bank/credit card statements were often sufficient as long as I could provide a clear business justification and the merchant was identifiable. For cash transactions without receipts, I created a detailed log showing date, amount, business purpose, and location. The IRS agent accepted this for smaller amounts, especially when the expenses were clearly business-related (like parking meters, tips at business meals, etc.). The key was being able to explain the business necessity of each expense. Regarding the shareholder agreement - we actually created it retroactively, which I was nervous about. But our tax attorney explained that as long as it documented what actually happened and reflected our true intentions at the time, it was acceptable. We included language stating that this agreement "memorializes the understanding between shareholders that existed at the time of the distributions." The IRS agent didn't question this approach, though they did scrutinize whether our stated intentions matched our actual transaction patterns. For reasonable compensation, the IRS looked at industry standards, my actual duties, time spent, and comparable salaries in our geographic area. They had me document hours worked and specific responsibilities. We ended up settling on a salary that was about 60% of what similar positions paid locally, which they accepted given our company's size and profitability. The retroactive documentation worked for us, but consistency and clear business reasoning were crucial throughout the process.

This is really helpful information about the loan vs. contribution analysis! I hadn't heard of this specific IRS procedure before. Your point about documenting the intent at the time of the transactions is crucial - that seems to be a common theme throughout this discussion. I'm particularly interested in your mention of the shareholder basis schedule. Is this something I need to file with my tax return, or is it just for internal record-keeping? Also, when you say "adjusted basis in the stock," does this include both the initial capital contribution when we formed the S-Corp plus any additional paid-in capital from personal expenses throughout the year? One thing I'm still unclear on - if I'm not required to file balance sheets with my 1120S (under the $250K threshold), how detailed do my internal records need to be to satisfy the "no expectation of repayment" and "intent to make capital contributions" requirements you mentioned? Would contemporaneous emails between shareholders discussing these transactions be sufficient, or do I need formal corporate resolutions for each transaction? Your approach seems much more systematic than what I was originally planning. It sounds like having a clear basis calculation will be essential for defending the return of capital treatment if questioned.

The shareholder basis schedule is for internal record-keeping only - you don't file it with your return, but it's crucial documentation to have if questioned. Your adjusted basis would include your initial capital contribution plus any additional paid-in capital (like those personal expenses you paid for business purposes), plus your share of S-Corp income, minus any distributions taken. For documentation without balance sheet requirements, you don't need formal resolutions for every transaction, but you should have consistent internal records. A combination of approaches works well: a detailed spreadsheet tracking all personal expenses paid for business (with business justification for each), email communications between shareholders acknowledging these as capital contributions, and a simple written agreement stating that personal funds used for business purposes are intended as capital contributions, not loans. The key is consistency - if you treat these as capital contributions in your records, make sure all your documentation supports that characterization. Don't mix loan language with contribution language in your records. One more critical point: make sure your return of capital doesn't exceed your total basis. If distributions exceed basis, the excess becomes taxable gain. So if you contributed $10K in personal expenses as capital, your initial investment was $5K, and S-Corp income allocated to you was $8K, your basis would be $23K. Any distributions above that amount would be taxable. This systematic approach will give you much stronger footing if the IRS questions your treatment of these transactions.