S-Corp Audit and Income Reclassification

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I am a 50% shareholder in an s-corp. My home state has just completed an audit for 2005. Through the audit, I have become painfully aware that my "partner" was running some pretty big personal expenses through the company. The vast majority of the items that turned up on the list are items that we always argued about internally as being legitimate - various credit card expenses, cars, boat, racing expenses, etc. In any case, I wrongly didn't worry about the questionable items because I didn't take any of the same liberties. I always figured that it was a risk that my partner was taking.

My ignorance was this: I was simply too stupid to realize the connection between disallowed expenses and my personal tax return. Now that the audit is complete, 50% of the disallowed expenses are now set to show up on my tax return in the form of distribution of profit. The problem is, of course, I never actually received the profit or distribution.

Putting aside the issue of fairness and equity between the two of us as 50/50 shareholders, my question is this: Is there any precedent for the re-classification of these expenses as unreported salary to my partner in lieu of them being unreported income? I am much more concerned about the tax implications of this issue than the other obvious problem of us not being squared up on distributions/salary.

Yes, I realize that I need professional help. But, in even just my short time working on this, I find opinions even between professionals to vary wildly.

Thanks for any advice.
 

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