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It is not OK but it would be better for everybody just keep that way and correct it going forward. If you wanted to correct it, you would have to amend all the payroll filing, including all quarterly and year end returns, issue corrected W2s to the partners, request refunds from IRS (at which point they will start asking questions) and partners would have to amend their personal returns as well. Because the statue of limitation for 2011 already expired and for 2012 expire soon, partners would probably loose any refunds for those years anyway.
Well, it happens more often than one may think. As a matter of fact this morning I received similar question from another client, a CPA who was preparing partner's returns. It is not wrong per se since taxes have been paid but IRS doesn't like such arrangement for other reasons.
Partnership is path through entity for tax purposes. Yes, they can have monthly, quarterly draws that will not be deducted on the partnership return so at the end of the year all the draws will be reported on K1s as part of the profit/loss. Depending on amount of taxes they will owe, they may to do some estimated payments. I usually advice my clients to sit down with the preparer in September or October and run a return projection. If they are behind, they can still make estimated payments by the end of the year.
Here are some risks associated with treating partners as employees:
It is safer to leave it and make corrections going forward than trying to fix it by amending all those years and requesting refunds for payroll taxes from IRS and CFB for all those years. And you will not be able to get any refund of taxes for 2011 because of the statute of limitation.
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