S Corp form 1120-S question

General
1

I’m confused by a hypothetical example our accountant gave when we were reviewing Form 1120-S:

  1. The business had a cash balance of $100,000 at the start of 2023, no interest income in 2023.
  2. The business generated no revenue in 2023.
  3. The business had no expenses in 2023.
  4. The sole shareholder of the business paid themselves $40,000 as a salary that year.

Her claim is that the net taxable income for the business is $0 for the year because the shareholder’s salary is taken out of their shareholder basis.

This doesn’t make sense to me. I thought the taxable income would be (-$40,000), but I’m not an accountant. Did I misunderstand something, or is this wrong? I’m trying to figure out if I should trust the accountant.

2

Did your accountant say ‘salary’ or ‘distribution’? That makes a big difference.

3

If the business had no activity during the year, what was the salary for? It sounds more like a distribution of previously taxed profits or contributed capital rather than a salary expense.

4

Kai said:
If the business had no activity during the year, what was the salary for? It sounds more like a distribution of previously taxed profits or contributed capital rather than a salary expense.

Exactly. Sounds like they’re trying to report a loss from an inactive S Corp to reduce personal income tax, which isn’t how the tax code works. This likely represents a shareholder distribution, not a salary. The loophole didn’t work.

5

If the $40K was simply transferred from the business account to you personally without issuing formal payroll or paying payroll taxes, then it’s a shareholder distribution, not a salary expense. In that case, the accountant is correct: the business shows zero taxable income, and the distribution reduces shareholder basis. If you wanted to claim it as salary, formal payroll would need to be completed, but I can’t see why you’d want to do that in this situation.

6

If this is salary, the S Corp would report a $40,000 loss. Your 1040 would then show $40,000 in wages (W-2 income) and a $40,000 S Corp loss, netting to zero on your personal return.

7

If this is a distribution, the calculation would look like this:

  • Beginning retained earnings: $100,000
  • Minus $40,000 distribution: $60,000 ending retained earnings.

If there’s not enough retained earnings, it reduces shareholder capital contributions instead. Retained earnings cannot go negative.

If it’s payroll, that creates a $40,000 expense, but it’s generally not advisable in a zero-revenue year due to costs and potential IRS scrutiny.

8

If your accountant said the taxable income is $0 because salary comes out of shareholder basis, they’re wrong. A $40,000 salary would create a corporate loss of $40,000 plus employer payroll taxes. The shareholder’s year-end basis would then be reduced by the net loss.

9

If your accountant genuinely believes this, it’s time to find a new one. This is Tax 101, and they seem clueless.