In the early stages of a partnership, it’s a common mistake: you start paying the founding partners a regular salary and, out of habit, your payroll software spits out a W-2 at the end of the year.

It feels organized, but there’s a catch—the IRS strictly prohibits partners from being treated as employees. If your partnership accidentally issued W-2s to owners, you have a “mismatch” on your hands that can trigger audits and messy tax notices. Here is the step-by-step guide on how to unwind the error and get your filings back in the clear.

---

1. The “Why”: Partners Aren’t Employees

According to IRS rules, a person cannot be both a partner and an employee of the same partnership.

• Employees receive W-2s and have taxes withheld by the company.
• Partners receive Schedule K-1s and pay their own self-employment taxes.

When you issue a W-2 to a partner, you are incorrectly paying the employer’s share of FICA taxes and withholding income tax that should be handled on the partner’s individual return.

2. The Correction Roadmap

To fix this, you have to “zero out” the payroll records and “re-characterize” those payments as partnership distributions or guaranteed payments.

Step A: Void the W-2s (Forms W-2c & W-3c)

You must tell the Social Security Administration that the W-2s were issued in error.

• File Form W-2c for each partner. You will list the original “wage” amounts in one column and $0 in the “Correct Information” column.
• File Form W-3c to summarize these changes for the government.

Step B: Reclaim Overpaid Taxes (Form 941-X)

Since the partnership likely paid employer-side Social Security and Medicare taxes on those “wages,” you’ll want that money back.

• File Form 941-X for every quarter in which the partners were paid through payroll.
• This form allows you to correct the over-reported wages and claim a refund or credit for the overpaid payroll taxes.

Step C: Reclassify the Income (Schedule K-1)

Now that the “wages” are gone, that money needs a new home. Usually, what was paid as a salary is reclassified as a Guaranteed Payment.

• Update your Form 1065 (Partnership Return).
• Issue a Schedule K-1 to each partner reflecting their share of profits and their guaranteed payments.
• Note: If you already filed the 1065, you will need to file an Amended Return.

---

3. The Impact on the Partners

This correction changes how the partners file their personal taxes. Because they no longer have taxes “withheld” from a paycheck, they will likely owe Self-Employment Tax on their Form 1040.

Pro Tip: Before you file these corrections, have a meeting with all partners. They need to be prepared for the fact that their W-2 is disappearing and their K-1 income is increasing, which may change their personal tax liability.

Need a Hand?

Fixing payroll errors involving owners is a technical process that requires precision across multiple tax years. If you’re staring at a stack of 941s and feeling overwhelmed, it’s best to consult a tax professional to ensure the “unwinding” process doesn’t trigger unnecessary penalties.