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There are two ways you can deal with this and the choice may not be yours.
You can record the obligation to the shareholders if the S Corporation is on the accrual basis. It will then take the deduction. The subsequent payment to the shareholders will not have taxes withheld and will be recorded on the S Corporation's records as a reduction in the obligation. The shareholders, because this is a closely held entity, must then declare the income in 2010 for tax purposes. When paid it will not be treated as taxable again. The key here is that this is only valid if the S Corporation is on the accrual method.
This choice is available whether the S Corporation is on the accrual basis or the cash basis. Do not record anything for this in 2010 on the S Corporation or individual shareholders' returns. When paid in 2011 taxes should be withheld and the expense recorded on the S Corporation's records and the shareholders' taxes.
The crucial point here is that both sets of tax reports must agree because of the closely held nature of an S Corporation.
So it would be reported as 409A income and also as nonemployee compensation on the 1099-misc. And basically the 409A income is deducted from the nonemployee compensation when taxes for 2010 are figured? Then it would be reported again in 2011 and that is when taxes will be paid?