K-1 on Schedule C

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#1
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I picked up a new client who has a SMLLC taxed as a disregarded entity that has ownership in a S-Corp. The prior CPA reported the K-1 on my clients Schedule C (no reference on E) and then deducted expenses against that income. I discussed this with the prior CPA and he said that he could not find anything in his research that told him he could not do that. His thought process is that disregarded entities are reported on the Sch C, and the expenses are valid.

I do not agree with this approach and do not plan on taking this approach with my client moving forward. My recommendation would be to have the S-Corp reimburse the expenses. However, if there is validity to his stance I would like to know. The issue that I have is the prior CPA is still preparing the S-Corp return and the other owners personal tax return. Because he "could not find anything that told him he could not do that" I believe that he is going to require me to find definitive proof that he is incorrect before he changes how he is handling the S-Corp return.

If you can point me to regs, court cases, or other info that specifically states that a K-1 cannot be reported on Sch C, that would be greatly appreciated.
 

#2
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**This should probably be in the Tax Forum...

This is patently wrong.
A Sch C is to report the activities of a trade or business owned by one person, a sole proprietorship.
The fact that this activity is an s-corp excludes it from this treatment at that level.
Additionally, there are very few expenses paid by the shareholder that are deductible against the flow through income. Acquisition interest is one of them. Expenses related to the trade or business activity of the s-corp need to be reimbursed by the s-corp as you suggest. Otherwise, they are employee business expenses to the individual and not currently deductible.

My guess is that the prior preparer wanted to deduct these employee business expenses, but couldn't. So, he cooked up this scheme to do so.
Finally, doesn't this approach end up subjecting the remaining net income to SE tax, which is usually the whole reason people have an s-corp to start with?

The whole thing is a sham.
~Captcook
 

#3
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A disregarded entity merely means that the entity is disregarded for income tax purposes. i.e. We pretend it does not exist. The character of the income determines where it goes on the 1040. Interest income would go to Sch B. An ordinary trade or business subject to SE AND operated by the DRE goes to Sch C. A rental not subject to SE and operated by the DRE goes to Sch E, Part I. A K-1 received by the DRE with box 1 or 2 populated would go to Sch E, Part II.

These are very basic concepts and I wouldn't spend too much time on it if it was me. I'd probably respectfully suggest the other CPA take a quality course that deals with K-1 reporting on the 1040, and ask the instructor questions. That's most likely the best use of everyone's time.
 

#4
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Thank you ManVS.Tax and Capt Cook for your responses. I agree with both of you. I think he is going to look for me to prove him wrong. As you noted ManVsTax this is such a basic concept that no one specifically addresses it...but ultimately that is problem I am running into.
 

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#6
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Duck Duck Goose wrote: I think he is going to look for me to prove him wrong.


If you really want to go down the rabbit hole with him (I wouldn't), as a thought exercise ask him where he'd reported $100k of interest income earned by the DRE on the 1040.

He can't answer that without being inconsistent or making himself look incompetent, IMO.

Duck Duck Goose wrote:As you noted ManVsTax this is such a basic concept that no one specifically addresses it...


Well the shareholder's instructions for Sch K-1 (1120-S) address where to report Box 1 and Box 2, but something tells me that won't mean a lot to this genius.

"he said that he could not find anything in his research that told him he could not do that." is in the same vein as "I didn't know I couldn't do that officer."
 

#7
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Duck Duck Goose wrote:I agree with both of you.


I think the more important question is: In what way does this other preparer's perspective influence you and your client?
Is it just the reimbursement? Is he advising the s-corp not reimburse items because they can be included on a Sch C?

If that's not it, I'd probably let it go if gaining the s-corp as a client isn't a goal.
I'd also have to think long and hard about whether I have enough faith the K-1 is accurate to feel comfortable filing the shareholder's return.
~Captcook
 

#8
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[quote="CaptCook"]
I think the more important question is: In what way does this other preparer's perspective influence you and your client?
Is it just the reimbursement? Is he advising the s-corp not reimburse items because they can be included on a Sch C?

My client has 50% ownership in the S-Corp and the business relationship can be contentious. The other CPA did this in an effort for both of the owners to be able to deduct expenses that they felt were valid, but did not want to share equally in. (again, I don't agree with any of this). So, if the prior CPA continues to allow his client to deduct those expenses on his schedule C, then there is no incentive for his client to work with my client on making them reimbursed by the S-Corp. He will simply deduct his on his schedule C and since his CPA is telling him that is ok refuse to reimburse my client at the S-Corp level...because my client could deduct it on his C, but is CHOOSING not to do so.
 

#9
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Are these expenses creating a loss against the K-1 income?
If not, you should explain how they are paying more tax (SE tax) than they should with this strategy.
That might start to turn the tide.
~Captcook
 

#10
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Why did the client leave the other CPA and come to you?
 

#11
sjrcpa  
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How long has this S Corp been around?
Profitable?
IRS matches K-1s now.
If they don't see the K-1 Line 1 income on a shareholder's return, they'll issue a matching notice.

Wonder what other CPA will say then.
I don't know if IRS will do that for a loss.
 

#12
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CaptCook wrote:Are these expenses creating a loss against the K-1 income?
If not, you should explain how they are paying more tax (SE tax) than they should with this strategy.
That might start to turn the tide.


K-1 box 1 is ~400k, ~100k of expenses deducted on Sch C. So, paying SE tax on roughly 300k. Costing the taxpayer about 10k additional in tax doing it this way as opposed to running it through the SCorp. However, if none of the 100k was deducted because you could not get the other owner to sign off on it, then he is coming out ahead.
 

#13
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sjrcpa wrote:How long has this S Corp been around?
Profitable?
IRS matches K-1s now.
If they don't see the K-1 Line 1 income on a shareholder's return, they'll issue a matching notice.

Wonder what other CPA will say then.
I don't know if IRS will do that for a loss.


That was my thought as well. Current structure with Sch C reporting started in 2020. In my mind it is just a matter of time before the IRS notice, but with as backed up as they are it could be years... if ever.
 

#14
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ManVsTax wrote:Why did the client leave the other CPA and come to you?


My client came to me because he felt like the other CPA may be biased to his business partner.
 

#15
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I don't see any reason to be nervous about what the other practitioner might say. If anything, he should be the nervous one.

Suggest the accountable plan when the time comes. If the other CPA starts a bunch of nonsense, point out that not only is he doing things incorrectly, but he's costing these shareholders an additional 5 figures in tax that they shouldn't be paying.

You might pick up the other shareholder and the S Corp as clients, and the potential problems will disappear.
 

#16
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ManVsTax wrote:I don't see any reason to be nervous about what the other practitioner might say. If anything, he should be the nervous one.

Suggest the accountable plan when the time comes. If the other CPA starts a bunch of nonsense, point out that not only is he doing things incorrectly, but he's costing these shareholders an additional 5 figures in tax that they shouldn't be paying.

You might pick up the other shareholder and the S Corp as clients, and the potential problems will disappear.



I appreciate your time and insight. Have a good one.
 


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