Jeremy Wells

Shared Business Activity—not Mere Co-Ownership—Often Determines Partnership Status

Earmark Team · July 20, 2026 ·

Two friends buy a short-term rental together. They split everything, from income and expenses to responsibilities, 50/50. One manages the bookings while the other handles repairs. They never wrote up any agreement, registered an LLC, or created any paperwork at all.

Did these friends accidentally create a partnership with federal filing requirements?

Now make it more complicated. What if those two friends are married? What if they’re flipping houses instead of renting them? What if one spouse does all the work while the other occasionally helps with administrative tasks?

These are real questions that come across the desk of tax professionals every week. While they might seem straightforward, the answers are anything but simple or academic Partnership status affects filing requirements, basis calculations, elections, self-employment tax, audit procedures under the BBA, and the availability of numerous Subchapter K provisions. That’s why correctly identifying whether a partnership exists is the first step in any partnership analysis.

In episode 31 of Tax in Action, Jeremy Wells, EA, CPA, tackles this tough question in small business taxation: When does co-ownership cross the line into a partnership under federal tax law? Drawing from IRC §761(a) and §7701, Treasury regulations, and Supreme Court cases dating back to the 1940s, Jeremy builds a practical framework you can apply to client situations starting today.

Determining whether a co-owned activity is a partnership requires more than checking if someone filed an LLC with the state. You need to analyze the shared profit motive, business activity, and genuine intent. The analysis is shaped by decades of court-tested criteria. You also need to understand the distinct exceptions available to married couples.

Get this analysis right, and you’ll meet reporting requirements while positioning clients for partnership planning opportunities. Get it wrong, and you face unfiled return penalties, missed planning strategies, or both.

The Federal Definition Casts a Wide Net (With Important Limits)

To determine if your client’s co-owned activity is a partnership, you first need to understand how broadly federal tax law defines the term and where it draws the line.

IRC §761(a) defines “partnership” to include syndicates, groups, pools, joint ventures, and other unincorporated organizations (excluding corporations, trusts, and estates). That’s remarkably broad. As Jeremy explains, essentially any business-like activity with more than one participant could qualify. Add the companion definition in IRC §7701(a)(2) and Treasury regulations, and you have a framework that captures far more arrangements than most people realize.

There’s also the familiar default rule: Under Reg. §301.7701-3(b), a domestic eligible entity with two or more members that hasn’t filed a corporate election is treated as a partnership. This is where we get “multi-member LLC equals partnership.” For foreign entities, you need to check whether any member lacks limited liability, but the domestic rule is straightforward.

Despite this broad sweep, the regulations carve out two important exceptions that do not create a separate entity for federal tax purposes:

A joint undertaking merely to share expenses
Mere co-ownership of property (even income-producing property)

That second exception matters most in everyday practice. Two unrelated people can buy a rental property together, split the income and expenses, and that alone doesn’t necessarily create a partnership.

Jeremy shares an example from Laura and Noel Cunningham’s textbook, The Logic of Subchapter K. Two people co-own a taxi cab. Each drives it 12 hours a day, tracking their own fares and expenses separately. No partnership exists because there’s no joint profit motive. What you earn during your shift has nothing to do with what I earn during mine.

But change the facts and lease that cab to a third party who pays both owners. Now you’ve introduced a collective profit motive, and it looks like a partnership.

The Cunninghams identify two key features: business activity and sharing of profit. When both exist, you likely have a partnership. When either is missing, you probably have mere co-ownership.

This is where things get tricky. A single rental property split between two friends is probably mere co-ownership. But if they offer concierge services for an extra fee or they’re building a portfolio of rentals and managing them like a business, each additional fact pushes the activity toward partnership territory.

As Jeremy emphasizes repeatedly, federal tax law, not state law, controls this determination. You can register an LLC, file articles and get a certificate of formation, but none of these facts, standing alone,

determines whether a partnership exists for federal tax purposes. As the Supreme Court established 75 years ago, states can create entities on their books, but they can’t dictate federal tax consequences.

When Partnerships Actually Form

Knowing a partnership can exist is one thing. Knowing when it forms and triggers filing obligations is another matter entirely. It has nothing to do with filing paperwork at the Secretary of State’s office.

A partnership forms for federal tax purposes when participants join capital or services together with the intent to conduct an enterprise or business. Courts generally look for both genuine intent to carry on a business together and some actual contribution of capital or services.

Plans, discussions, and handshake agreements don’t count. Something tangible must go into the pot.

This framework comes from two landmark Supreme Court decisions every practitioner should know.

Tower v. Commissioner (1946) laid the foundation. The Supreme Court held that a partnership forms when people join “their money, goods, labor, or skill for the purpose of carrying on a trade, profession, or business” with a “community of interest in the profits and losses.” The critical question: whether the partners “really and truly intended to join together for the purpose of carrying on business and sharing in the profits or losses.”

Tower also drew a bright line between state and federal authority. As the Court stated, a state “cannot, by its decisions and laws governing questions over which it has final say, also decide issues of federal tax law.”

Culbertson v. Commissioner (1949) clarified what Tower meant. Lower courts misread Tower as requiring some minimum threshold of capital or services. The Supreme Court corrected this, saying, “The question is not whether the services or capital contributed by a partner are of sufficient importance to meet some objective standard,” but whether “considering all the facts, the parties in good faith and acting with a business purpose intended to join together in the present conduct of the enterprise.”

Culbertson produced the factors courts use to assess intent, and practitioners should memorize these criteria:

The agreement and the parties’ conduct in executing it
Whether each participant genuinely participates or is just a name on paper
Testimony of disinterested persons (would vendors or advisors see this as a partnership?)
The relationship of the parties
Their abilities and capital contributions
Actual control of income and how it’s used
Any other facts showing true intent

Jeremy notes that family partnership cases of the 1940s-1960s drove much of this development. Families were forming partnerships primarily for tax benefits. Courts had to determine whether these were genuine business partnerships or just tax avoidance vehicles. When the intent was purely to dodge taxes rather than to operate an enterprise, courts rejected partnership status.

Sparks v. Commissioner (1986) adds practical guidance. The Tax Court held that startup discussions, soliciting contributions, negotiating with third parties, and even incurring expenses were “pre-operating activities,” not partnership formation. The partnership didn’t form until members’ capital interests vested, meaning contributions were made and ownership interests received.

The practical takeaway is to document everything. Jeremy emphasizes that small business owners are terrible at this, and tax advisors must encourage better practices. A partnership or operating agreement that records when contributions were made and the ownership interests received establishes the formation date, not the LLC filing, planning meeting, or domain registration.

Three Ways to Avoid Partnership Treatment

Once you’ve determined a partnership exists, the next question is whether an exception allows the parties to sidestep partnership reporting. Three pathways exist, and practitioners regularly confuse them.

Electing Out of Subchapter K

Under IRC §761(a), members of an unincorporated organization can elect out of Subchapter K treatment if they can determine their incomes individually and the activity involves:

Investment purposes only
Production, extraction, or use (but not sale) of joint property
Securities underwriting over a short period

But the catch is that this election only removes Subchapter K rules. It doesn’t exempt the activity from any other IRC provision.

Jeremy highlights Cokes v. Commissioner (1988) as the cautionary tale. A widow inherited her husband’s interest in an oil venture that had elected out of Subchapter K. She never attended meetings, voted, drilled wells, or supervised operations. Her involvement was zero beyond holding an interest. Still, the Tax Court held her income was from a trade or business, subject to self-employment tax under IRC §§1401 and 1402. The partnership remained a partnership, just not subject to Subchapter K.

Qualified Joint Venture for Married Couples

The first spousal exception is available only to couples filing jointly who meet all three requirements:

The spouses are the only members
Both materially participate under IRC §469(h)
Each reports their share as if operating as a sole proprietor (separate Schedules C (or F) and separate Schedules SE)

This splits what would be a partnership into two sole proprietorships for reporting, eliminating Form 1065.

A critical limitation to be aware of is the qualified joint venture is NOT available if spouses operate through an LLC. If they registered an LLC, this door is closed.

There’s no form to file. Spouses simply submit separate schedules with their joint return. The election continues while requirements are met. Revocation needs IRS permission.

Community Property LLCs

The second spousal exception applies when there IS an LLC, exactly where the qualified joint venture fails. But it only works in nine community property states: Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin.

To be eligible, the LLC must be wholly owned by spouses as community property with no corporate election filed. When met, Rev. Proc. 2002-69 lets spouses report the activity as either a partnership or a disregarded entity.

This isn’t an election, so there’s no form, statement, or revocation. It’s simply a choice the IRS respects. Spouses can theoretically change annually (though Jeremy says they probably shouldn’t).

Your Two-Step Framework for Partnership Determination

Jeremy distills everything into a practical framework you can apply immediately.

Step 1: Does a partnership exist?

Ask these questions in order:

Are there two or more distinct owners? (Not an individual and their disregarded entity. They have to be two separate taxpayers)
Are they merely co-owning property, or operating a business together?
Is there a shared profit motive? Do they act like business co-owners or like investors holding the same asset?

The more parties look like business owners running an enterprise together, the more likely a partnership exists.

Step 2: Does an exception apply?

Check for:

§761(a) election out of Subchapter K
Qualified Joint Venture under §761(f) (spouses, joint return, no LLC)
Community Property LLC under Rev. Proc. 2002-69 (spouses, community property state, LLC)

Key Takeaways for Tax Professionals

Shared property doesn’t create a partnership. Shared business activity does. One rental is probably co-ownership. A portfolio with services looks different.
State entity formation doesn’t control federal partnership status. The Supreme Court settled this in 1946.
Partnerships form when participants contribute capital or services in exchange for ownership interests, not when they form an LLC or buy a domain. Document that moment.
Push clients toward written agreements. Small business owners resist this. Partnership or operating agreements that record contributions and formation dates are essential.
Don’t confuse the spousal exceptions. Qualified joint ventures and community property LLC rules are completely separate regimes for different situations.
Electing out of Subchapter K doesn’t avoid self-employment tax or any other IRC provision.

These determinations have real consequences. Get it right, and you’ve met reporting requirements while positioning clients for planning opportunities. Get it wrong, and you face unfiled returns, unexpected self-employment tax, or missed savings.

If you’re ready to dive deeper, listen to the full episode of Tax in Action for all the case law details, regulatory citations, and Jeremy’s complete analytical framework. In the next episode, Jeremy examines who qualifies as a partner and tackles the increasingly important question of which partners face self-employment tax.

Beyond the Stock Sale: Allocating Purchase Price When S Corp Assets Sell Individually

Earmark Team · July 7, 2026 ·

When a buyer offers $1 million for your client’s S corporation, the simplest path is a stock sale. There’s one transaction, one gain calculation, and you’re done. Purchase price minus stock basis equals gain. You could calculate it on a napkin. But most buyers don’t want simple. They want to crack open the corporate shell, pick out only the income-generating assets, and leave the entity (and its liabilities) behind. That’s when your job as a tax practitioner gets exponentially more complex.

In Episode 30 of Tax in Action, Jeremy Wells, EA, CPA, walks practitioners through the intricate mechanics of S corporation asset sales, building directly on the stock sale fundamentals he covered in Episode 29. Using Lighthouse LLC, a fictional single-shareholder S corp with a $1 million offer on the table, Jeremy demonstrates how to classify assets across seven categories, allocate purchase price using the residual method, calculate gains with proper character for each asset, and report everything correctly on Form 8594.

The shell versus what’s inside

Jeremy opens with a metaphor that captures the distinction. “One way to think about this is buying the shell and everything that’s inside the shell, or just cracking open that shell and buying only the stuff inside of it and leaving the shell behind.”

In a stock sale, the buyer acquires the entire entity. Every asset and liability, the brand name, the corporate history, etc. It’s one transaction. For Jessica, the 100% owner of Lighthouse LLC with a $250,000 stock basis, a $1 million stock sale means a $750,000 gain. Simple capital gain calculation. Done.

But the buyer in Jeremy’s example wants something different. Lighthouse LLC carries significant liabilities tied to its property and equipment. The buyer wants the income-producing assets, including the equipment, building, land, customer relationships, and goodwill, but not the debt. Not the entity itself.

This preference flips everything for the tax practitioner. Instead of one gain calculation, you now have to analyze every individual asset on the balance sheet and beyond.

Why buyers insist on asset sales (and why sellers often resist)

Jeremy explains buyers push for asset sales for two compelling reasons.

Stepped-up basis opportunity

When buyers purchase assets directly, they own them outright, not through a corporate intermediary. “It’s as if the buyer purchased those assets from the manufacturer or from the retailer. It’s going to be an original placement into service of those assets by the buyer,” Jeremy explains.

This means depreciation starts fresh. The buyer’s basis in each asset equals the allocated purchase price, not whatever the seller paid years ago. This reset can be enormously valuable for a building the seller has been depreciating for a decade. Nothing changes in a stock sale. The buyer inherits the existing depreciation schedule exactly as it stands.

Avoiding unwanted liabilities

In an asset sale, debts stay with the corporate shell. The buyer takes the assets clean. This is an important distinction for Lighthouse LLC, with its property-related debt.

Sellers, meanwhile, generally prefer the simplicity of stock sales. Jeremy notes they “often produce just a single capital gain, and they avoid the complexity of having to allocate purchase price among assets.” But when buyers insist on asset purchases (and they usually do), sellers often agree, especially when they want to retain the entity for future use or restructuring opportunities.

The residual method

Once both parties agree to an asset sale, IRC Section 1060 takes control, and Jeremy emphasizes this isn’t optional. If you’re selling assets that constitute a trade or business and the buyer’s basis will be determined by the purchase price, Section 1060 always applies.

The section mandates the use of the residual method to allocate the purchase price across seven asset classes, working sequentially from Class 1 through Class 7. Jeremy compares this to reading down a balance sheet because the most liquid assets come first and the least liquid come last.

Here’s how Lighthouse LLC’s assets break down:

Class 1 (Cash): $50,000. No gain possible. Cash is just cash.
Class 2: None in this example (would include actively traded securities, CDs, foreign currency)
Class 3 (Accounts receivable): $100,000 fair market value, but zero tax basis for this cash-basis taxpayer. That means $100,000 of ordinary income.
Class 4 (Inventory): None in this example
Class 5 (Tangible assets):
- Equipment: $100,000 tax basis, $50,000 FMV
- Building: $300,000 tax basis, $400,000 FMV
- Land: $100,000 tax basis, $150,000 FMV
Class 6 (Intangibles except goodwill): Customer list valued at $100,000, zero basis
Class 7 (Goodwill): The residual is whatever’s left after allocating to Classes 1-6

With $850,000 allocated to identifiable assets and a $1 million purchase price, the remaining $150,000 becomes goodwill.

But Jeremy offers a crucial warning: “You can’t just treat all Class 5 assets the same because they’re Class 5.” Each asset needs individual analysis. Equipment might trigger Section 1245 recapture. Buildings might trigger Section 1250 recapture. Land never has recapture because it’s never depreciated. Every asset has its own character of gain.

The invisible assets that drive real value

Jeremy dedicates some time to intangible assets because, especially in service businesses, “goodwill actually is the largest asset.”

Treasury regulations define goodwill as “the value of a trade or business attributable to the expectancy of continued customer patronage.” It includes reputation, brand recognition, a trained workforce, documented procedures, modern technology application, and consistent lead generation.

However, “It’s never appropriate to add goodwill, especially self-generated goodwill, to a balance sheet, unless you have a sales transaction,” Jeremy shares. Goodwill doesn’t get a balance sheet value until a buyer actually pays for it.

Practitioners must also watch for personal versus corporate goodwill. Jeremy references Martin Ice Cream Company v. Commissioner, where the Tax Court held that when goodwill exists because of one individual’s personal relationships with customers and vendors, it belongs to that individual,

not the corporation. This distinction has a big impact on reporting in small professional firms where the owner is the brand.

Covenants not to compete present another wrinkle. They’re Class 6 intangibles, not goodwill, so you must separately identify and value them. Jeremy explains these are especially common in professional firm acquisitions, where the buyer doesn’t want the seller to start a competing practice nearby.

For the buyer, goodwill becomes a Section 197 intangible, subject to 15-year straight-line amortization with no acceleration through bonus depreciation or Section 179. For the seller, it’s Section 1231 property with zero basis, meaning the entire allocated amount is gain.

Your workflow

Jeremy provides a clear workflow for every practitioner to follow:

Get all documents first. You should have a copy of the signed purchase agreement and allocation schedule or proforma Form 8594. Both parties must report identical allocations.
Allocate the purchase price using Section 1060’s residual method
Calculate gain and character for each asset
Report on Form 8594 attached to the return
Pass gains to shareholders via Schedule K-1
Adjust shareholder basis for the pass-through gains
Handle liquidating distributions. Typically long-term capital gain at preferential rates

Jeremy shares a moment of professional conviction. “The client wanted me to just make up some numbers, and I simply would not go along with that.” He won’t prepare the return without proper allocation documentation agreed to by both parties.

His due diligence checklist adds crucial considerations:

Review prior depreciation schedules and shareholder basis calculations
Check state transfer taxes and sales taxes on tangible property
Evaluate installment sale benefits under Section 453. But remember, no help with depreciation recapture or inventory.
If the S corp was ever a C corp, check for built-in gains tax under Section 1374

Jeremy also mentions two elections that can treat stock sales as asset sales: Section 338(h)(10) and Section 336(e), though their complexity puts detailed discussion beyond this episode’s scope.

Bringing it all together for your practice

Asset sales are some of the most complex transactions you’ll handle as a tax practitioner. Where a stock sale for Lighthouse LLC requires one line of math, the asset sale demands individual analysis of every asset across seven classes, each with its own basis, fair market value, gain character, and recapture rules.

The residual method provides structure, but it’s not simple. Intangible assets are often the most valuable components of service businesses, and they’re invisible on the balance sheet until the sale takes place. You risk serious reporting errors if you don’t follow the documentation requirements.

Jeremy developed his systematic approach through classroom teaching and real-world practice. And it gives you the framework to handle these transactions correctly. The key is recognizing that in asset sales, you’re not selling one thing; you’re selling every individual asset, and each one has its own tax story to tell.

For the complete technical discussion and to hear Jeremy work through the full Lighthouse LLC example, listen to Episode 30 of Tax in Action. And if you haven’t already, start with Episode 29 on stock sales. Understanding that simpler transaction makes the complexity of asset sales much clearer.

Why an S Corporation’s Retained Earnings, AAA, and Stock Basis Rarely Match

Earmark Team · June 1, 2026 ·

S corporations sit at an awkward intersection of tax law. As Jeremy Wells, EA, CPA, explains in Episode 28 of Tax in Action, they’re hybrid entities that blend the tax and accounting rules of corporations with pass-through entities like partnerships. This blending creates something that exists solely in federal tax law. There’s no such thing as an “S corporation” in everyday business activity. It’s a creation of Subchapter S of the Internal Revenue Code, a tax fiction that forces us to track three different ledgers, often confusing even experienced practitioners.

Jeremy frames these three ledgers with a simple framework: retained earnings answers what happened, AAA (Accumulated Adjustments Account) determines what kind, and stock basis tells us how much. Each serves a distinct purpose, and understanding their differences is critical to avoiding costly errors in S corporation taxation.

Three Measures, Three Different Questions

The confusion starts because these ledgers often produce identical numbers, especially in simple scenarios. This similarity lulls practitioners into thinking they should always match. But as Jeremy emphasizes throughout the episode, each ledger answers a fundamentally different question about the S corporation and its shareholders.

Retained Earnings: What Happened Over Time

Retained earnings is the most familiar concept. It shows accumulated undistributed profits over the corporation’s lifetime. At the end of each accounting period, net income and distributions close out to retained earnings, leaving you with a running total of everything the corporation earned but didn’t pay out.

Critically, retained earnings has no floor. It can be a negative number if a corporation distributes more than it ever earned, or if it has accumulated losses over time. As Jeremy notes, some GAAP rules suggest calling negative retained earnings “accumulated losses.”

Unlike the C corporation’s Form 1120, Form 1120-S doesn’t include a retained earnings reconciliation. The IRS knows this. Jeremy points to IRM 4.10.3.8.2.2, which instructs examiners to review retained earnings for unexplained increases, as such jumps often indicate unreported income. If you can’t explain every change in retained earnings, an examiner will ask you to.

AAA: What Kind of Income

The Accumulated Adjustments Account might be, as Jeremy calls it, “one of the most misunderstood concepts of the S corporation as a whole.” It tracks the accumulated undistributed pass-through taxable income of the S corporation. That doesn’t include all profits, just the S corporation’s pass-through earnings.

History can explain why this distinction matters. Subchapter S was added to the tax code in the late 1950s, roughly two decades before Wyoming passed the first LLC law. Most early S corporations weren’t LLCs electing S status. They were C corporations converting to S status. AAA exists to separate the old C corporation earnings (which generate taxable dividends when distributed) from the S corporation’s pass-through income (which comes out tax-free).

Jeremy hammers home that AAA is a corporate-level measure. Even with a single 100% shareholder, AAA tells you nothing about how distributions affect that specific person’s tax return. It only tells you whether the corporation is distributing S corp earnings or C corp dividends.

Stock Basis: How Much

Only stock basis determines actual tax consequences for individual shareholders. This ledger answers the questions that matter to your clients, such as whether their losses will be deductible or suspended and whether their distributions are tax-free or trigger capital gain.

Stock basis differs from the other two ledgers because it’s shareholder-specific. While retained earnings and AAA belong to the corporation, basis belongs to the person. Since around 2021, it’s been reported on Form 7203, with Part 3 being especially critical for tracking allowable losses, deductions, and carryover amounts.

Jeremy notes that Form 7203 is filed at the shareholder level, not the corporate level. Even if the K-1 package includes a corporate version of the form, the official filing happens with the shareholder’s return, and the preparer needs to verify every number.

Where the Three Ledgers Split Apart

To demonstrate how easily these ledgers diverge, Jeremy walks through a first-year example. Jessica registers Lighthouse LLC as the sole member, funds it with $1,000 from her savings, and elects S corporation status. In year one, the corporation earns $84,000 of ordinary income, receives $500 in municipal bond interest, incurs $4,000 in nondeductible meals and entertainment expenses, and pays Jessica $35,000 in distributions.

Here’s where each ledger lands:

Retained Earnings: The $84,000 income increases it. The $500 tax-exempt interest increases it. The $4,000 nondeductible expenses and $35,000 distributions decrease it. Total: $45,500.
AAA: The $84,000 income increases it. The $4,000 expenses and $35,000 distributions decrease it. But the $500 tax-exempt income doesn’t touch AAA. It goes to the Other Adjustments Account (OAA) instead. The $1,000 capital contribution also bypasses AAA. Total: $45,000.
Stock Basis: Everything affects basis, including the $1,000 contribution, the $84,000 income, the $500 tax-exempt income, minus the $4,000 expenses and $35,000 distributions. Total: $46,500.

Three different numbers from perfectly ordinary transactions. As Jeremy emphasizes, “there is nothing locking these three ledgers together.”

The specific items that cause divergence aren’t unusual:

Capital contributions increase only stock basis. Jeremy sees preparers incorrectly running these through AAA or retained earnings, but they should go directly to the balance sheet as capital stock or additional paid-in capital.
Tax-exempt income increases retained earnings and basis but not AAA. If you worked with businesses during the COVID-19 pandemic, you’ve seen this with PPP loan forgiveness and the pre-EIDL grants. Both created tax-exempt income that went to OAA, not AAA.
Distributions affect all three ledgers differently. They reduce retained earnings without limit, reduce AAA but not below zero, and reduce basis with tax consequences if exceeded.

The Costly Errors That Follow

Understanding the theory is one thing. Recognizing the practical mistakes is where Jeremy’s guidance becomes invaluable for practitioners.

The “Loans to Shareholder” Trap

Jeremy sees this error often. When distributions exceed a shareholder’s basis, IRC Section 1368 requires treating the excess as capital gain. Instead, preparers record the excess on the balance sheet as “loans to shareholder” without any promissory note, repayment schedule, or reported interest income.

This is a misclassification. As Jeremy notes, both the IRS and courts consistently reject these arrangements when no bona fide debtor-creditor relationship exists. If you’re reviewing a return with loans to shareholders that never decrease or only increase, start asking for documentation. Without it, you’re likely looking at misclassified distributions that should have triggered capital gain.

Missing Capital Contributions

There’s a trap for 1040 preparers who don’t also prepare the 1120-S. Nothing on the K-1 explicitly reports capital contributions. Unless the corporate preparer adds a note, that contribution is invisible. Jeremy recommends asking every S corporation shareholder client every year, “Did you make any contributions to this S corporation?” Skip the question, and you’ll understate the basis.

Suspended Losses at Termination

This one catches clients by surprise. IRC Section 1366(d)(3)(A) permanently disallows suspended losses due to insufficient basis when the S election terminates. They don’t release like passive activity losses. During the post-termination transition period, shareholders can contribute capital to create basis and claim those losses. After that window closes, they’re gone forever.

The Order-of-Operations Election

Jeremy highlights an often-overlooked election under Regulation 1.1367-1(g). Normally, nondeductible expenses reduce basis before deductible losses. If those expenses use up remaining basis, the deductible losses suspend while the nondeductible amounts simply disappear.

Shareholders can elect to flip this order, preserving deductible loss carryovers at the expense of nondeductible items. The election is permanent, so revoking it requires IRS permission. Jeremy specifically mentions this could benefit cannabis businesses operating under IRC Section 280E, which face substantial nondeductible expenses.

Practical Takeaways for Your Practice

Jeremy emphasizes that S corporation shareholders need to know their basis and should perform mid-year tax projections. Basis is calculated at year-end or upon stock disposal, but projecting it mid-year helps avoid surprises like taxable distributions or suspended losses.

The three ledgers framework provides clarity in a complex area. Retained earnings shows what happened over the corporation’s life. AAA shows what kind of transactions occurred. Stock basis shows how much in limitations apply to each shareholder. Keep these distinctions clear, and you’ll avoid the errors that trip up even experienced practitioners.

Listen to the full episode for Jeremy’ complete discussion, including additional nuances about basis calculations and real-world applications that go beyond what’s covered here. The next episode of Tax in Action builds directly on these basis concepts, explaining what happens when shareholders actually sell their S corporation stock.

What Social Media Tax Advice Gets Wrong About Business Vehicle Write-Offs

Earmark Team · May 31, 2026 ·

Social media influencers love to throw out tax advice about having your business purchase a vehicle to claim big expenses, especially accelerated depreciation. Sometimes this advice even goes out to people who aren’t self-employed. But as Jeremy Wells, EA, CPA, explains in Episode 27 of Tax in Action, there’s more to deducting the business use of a vehicle than what these influencers would have you believe.

“For most self-employed folks and small business owners, buying a vehicle in the name of your business is probably a bad idea,” Wells argues. The tax law doesn’t care whose name is on the title. It cares about how you use the vehicle, trip by trip. And for most small business owners, you can usually get the same tax effect by owning the vehicle personally.

The episode walks through the statutory framework, including IRC §162, §262, §274, and §280F, along with regulations, revenue rulings, and court cases that govern vehicle deductions. Wells also shares a three-question framework to help determine the best approach for each client’s specific situation.

What Makes Vehicle Use Deductible (And What Doesn’t)

The foundation starts with IRC §162, which allows taxpayers to deduct ordinary and necessary operating expenses of a business. Wells points out that the statute says nothing about ownership; it addresses operating expenses of an automobile used in a trade or business. Meanwhile, IRC §262 says personal, living, and family expenses are not deductible, including commutes between your residence and your place of business.

The key comes from Revenue Ruling 99-7, which Wells emphasizes clearly lays out the difference between a business trip and a personal trip. “We need to think about whether each specific trip is business or personal,” he explains. The unit of analysis is the trip itself, defined by both its origin and destination.

Deductible trips include:

Travel from your main workplace to another workplace in the same area (like visiting a customer)
Attending off-site business meetings in your local area
Driving to a temporary work location outside your metro area

But if a trip begins or ends at your personal residence, it’s typically a commute, meaning it’s personal and nondeductible.

“When I look through a client’s mileage logs, I filter that mileage log in a spreadsheet for the personal residence of that client,” Wells says, sharing his approach. “Nine times out of ten, a lot of those trips begin or end with the taxpayer’s personal residence.”

There’s an important exception. The Tax Court found in Curphey v. Commissioner that trips between a bona fide home office and other work locations are deductible. If your home office qualifies under §280A(c)(1)(A) as your principal place of business, then your residence becomes a business location. But Wells cautions, “It’s not a home office just because you say it’s a home office. It’s a home office because it’s your primary place of working.”

This principle goes back to the Supreme Court’s 1946 decision in Flowers v. Commissioner, which held that business trips must be motivated by “the exigencies of business rather than the personal conveniences and necessities of the traveler.”

The Strict Substantiation Rules You Can’t Ignore

IRC §274(d) requires strict substantiation of vehicle expenses, including the amount, time, location, and business purpose. Wells explains there are two standards: adequate records and sufficient evidence.

“Adequate records” is what taxpayers should strive for: a contemporaneous log combined with documentary evidence like receipts. Wells specifically recommends smartphone apps. “One I usually recommend is MileIQ.” These apps use your phone’s GPS to automatically detect and record trips. “As soon as your phone’s GPS recognizes that you’re moving faster than a normal human being can walk or run, it assumes that’s a trip in a vehicle.”

Without adequate records, taxpayers fall back on “sufficient evidence,” or their own statement plus whatever corroborating evidence they can find, like bank statements showing fuel purchases. But Wells warns, “usually the IRS and the courts will see right through” reconstructed logs created from memory.

The strict substantiation rules of §274(d) supersede the Cohan rule, which normally allows courts to estimate expenses. This catches many practitioners off guard. But Wells puts it bluntly: “When it comes to vehicle use, Congress has effectively eliminated judicial mercy.”

The Depreciation Trap

IRC §280F limits annual depreciation for “listed property,” including passenger automobiles, defined as four-wheeled vehicles rated at 6,000 pounds or less of unloaded gross vehicle weight. The IRS publishes inflation-adjusted limits every year.

But it gets tricky under §280F(d)(2). You can only deduct the portion of depreciation attributable to qualified business use, yet your basis in the vehicle drops by the full depreciation amount, including the nondeductible personal portion. For example, if maximum depreciation is $5,000 and business use is 60%, only $3,000 is deductible, but basis still drops by the full $5,000.

The real danger comes when business use patterns change. As long as business use stays above 50%, normal MACRS depreciation applies. But if business use drops below 50% in any subsequent year, two things happen:

You must switch from MACRS to the Alternative Depreciation System (ADS), which is essentially straight-line depreciation with longer recovery periods.
You must recapture as ordinary income all excess depreciation, which is the difference between what you claimed and what would have been allowable under ADS from the start.

“Accelerated depreciation and especially Section 179 expensing are wagers on future business use,” Wells explains. “You’re essentially gambling that the business use of that vehicle will never drop below 50%.”

There’s another complication for business-owned vehicles. When an employee uses them (including S corporation shareholder-officers), the business use is a nontaxable working condition fringe benefit. But any personal use, including commuting, becomes taxable compensation under §274(l). That means payroll taxes on top of income taxes.

A Three-Question Framework To Cut Through the Complexity

Wells uses three questions to analyze any vehicle situation:

Who owns the vehicle?
Who uses the vehicle?
What percentage of use is for business and how is that expected to change over time?

“In my experience, most mistakes and complex situations arise when taxpayers ignore at least one of these three questions, or the answer to one of these three questions,” Wells says.

He demonstrates with three scenarios involving Jessica and her business, Lighthouse LLC:

Scenario 1: Jessica’s LLC is a sole proprietorship. She uses her personal vehicle 80% for business, but trips begin or end at her residence. A friend recommends buying a vehicle through the LLC for depreciation. “For tax purposes, it makes no difference,” Wells says. The LLC is disregarded, so she deducts expenses the same way regardless of ownership. Plus, Wells notes business ownership usually means “higher financing costs, especially in terms of the interest rate, and higher insurance costs.”

Scenario 2: Now Lighthouse LLC is an S corporation. If the corporation owns the vehicle and Jessica uses it personally, that personal use becomes taxable wages. “A much simpler approach,” Wells says, “would be to reimburse her for the mileage or for the business portion of her actual operating expenses under an accountable plan.”

Scenario 3: The LLC owns the vehicle, but Jessica’s business use has dropped from 80% to 60% and continues declining. She has three options:

Prepare for recapture by making estimated payments (least desirable),
Reduce personal use to keep business use above 50%, or
Distribute or sell the vehicle before crossing the threshold.

“Once business use drops below 50%, that recapture is unavoidable,” Wells says.

The Simpler Alternative: Standard Mileage Rate

Treasury regulations allow taxpayers to use the IRS’s annually published standard mileage rate instead of tracking actual expenses and depreciation. You multiply business miles by the rate, and parking, tolls, auto loan interest, and property taxes remain separately deductible. Everything else, including fuel, maintenance, and insurance, is included in the rate.

“It makes it relatively easy,” Wells says, especially when using a smartphone app for tracking.

The Bottom Line for Tax Professionals

Wells closes with wisdom worth remembering: “The best vehicle strategy is not the one that maximizes this year’s deduction. It’s the one you can defend three years from now.”

For most small business owners, personal ownership of the vehicle combined with proper substantiation and accountable plan reimbursements delivers the same tax benefits without the complexity of business ownership. The key is understanding that deductibility depends on how you use the vehicle, not whose name is on the title.

Having a qualifying home office often provides more value than business vehicle ownership by converting commutes into deductible business trips. And when it comes to depreciation, remember that accelerated write-offs are a bet that business use will stay high. That’s a bet many small business owners will lose as their business evolves.

Listen to the full episode for Wells’ complete analysis of every code section, regulation, and court case discussed here.

Your Client Got a W-2 and a 1099 from the Same Company. Here’s How to Handle It

Earmark Team · May 15, 2026 ·

Your client slides a W-2 and a 1099-NEC across the desk. Both are from the same company for the same tax year.

“Can this be right?” they ask.

Your gut says error. Often, it is. But sometimes that dual reporting is perfectly legitimate. Knowing the difference, and what to do when it’s wrong, separates a competent preparer from the advisor clients can’t afford to lose.

This is the territory Jeremy Wells, EA, CPA, covers in Part 2 of his worker classification series on the Tax in Action podcast. If you caught Part 1, you already know the common law control test for determining whether someone is an employee or contractor. Part 2 goes deeper into the statutory categories that break that simple binary wide open.

Statutory Employees: The Hybrid Category Most Practitioners Overlook

Beyond corporate officers (always employees) and common law employees (determined by the control test), the Internal Revenue Code creates a third category that confuses even experienced practitioners.

IRC Section 3121(d)(3) defines four occupational groups treated as employees for FICA and sometimes FUTA purposes, but not for federal income tax withholding. This hybrid status creates unique reporting requirements you need to understand.

The four groups are:

Agent or commission drivers (FICA + FUTA): Workers distributing meat, vegetables, fruit, bakery products, beverages other than milk, or laundry/dry cleaning services
Full-time life insurance salespersons (FICA only)
Traveling or city salespersons (FICA + FUTA)
Home workers (FICA only): Traditionally textile workers, but now including typing and transcribing services

Jeremy emphasizes an important point. “Home workers” doesn’t mean anyone working from home. It’s a specific statutory category.

To qualify as a statutory employee, these workers must meet three requirements. First, the contract must state the worker will personally perform all the work; no delegation allowed. If they can subcontract, they’re an independent contractor. Second, they can’t have substantial investment in facilities beyond transportation. Owning a delivery truck is fine; investing in other equipment probably disqualifies them. Third, there must be an ongoing work relationship, not a one-time gig.

Here’s where it gets interesting for practitioners.

Statutory employees receive a W-2 with box 13 checked. But that W-2 doesn’t go on page one of the 1040 as wages. Instead, it goes on Schedule C as gross income. The worker can then deduct related business expenses. That’s a huge advantage regular employees lost when the Tax Cuts and Jobs Act eliminated unreimbursed employee business expenses.

But there’s a catch. This income isn’t subject to self-employment tax because FICA was already handled through employer withholding. You must keep this Schedule C completely separate from any self-employment activity. And you can’t use this income to fund a SEP IRA or Solo 401(k).

Full-time life insurance salespersons get special treatment. They’re eligible for certain employee benefits from their companies. The other three statutory employee categories are independent contractors for benefit purposes. But even insurance salespersons can’t use their compensation for self-employed retirement plan contributions. “This is one of those cases where tax law just kind of won’t make sense,” Jeremy notes.

When Workers Are Never Employees, and When They’re Both

The code also designates three categories of workers who are never employees, no matter what.

First, sitter placement services under IRC Section 3506. Someone who only connects babysitters or caregivers with families isn’t the sitter’s employer as long as they’re paid on a fee basis and don’t handle wages. They’re just a third party making introductions.

Second and third are qualified real estate agents and direct sellers, covered by IRC Section 3508. Real estate agents need a license, commission-based pay, and a written contract stating they’re not employees. Jeremy notes this is “almost a universal arrangement” between brokerages and agents. Direct sellers follow similar rules. They sell products outside permanent retail establishments with commission pay and non-employee contracts.

This brings us back to our opening question. Can someone legitimately get both a W-2 and 1099 from the same company?

Yes. Revenue Ruling 58-505 tackled this exact situation. Insurance company workers served as corporate officers (running the company) and independent sales agents (selling policies). The IRS said they were employees for officer duties but contractors for sales activities.

“Imagine a corporate officer who also sits on the board of directors,” Jeremy says, offering a common example. “In fact, this is fairly common for a lot of companies, especially smaller family held companies.” If board service warrants separate compensation, they could receive employee wages for their officer role and contractor pay for director duties.

But dual reporting isn’t always this clean. “I’ve seen cases where the worker did not have the necessary paperwork to the employer in time to be on payroll when that worker had already been working,” Jeremy says. Sometimes a bookkeeper or tax advisor discovers mid-year that someone’s been misclassified all along. “I’ve been in the position where I’m the one having to have this conversation with a client,” he admits.

When you see both forms from one company, ask questions. What services generated each form? The answer determines whether you’re looking at a legitimate dual arrangement or a classification problem that needs fixing.

The Relief Toolkit When Classification Goes Wrong

Classification mistakes happen. Jeremy calls them “inevitable.” Knowing which relief mechanisms to use can mean the difference between a manageable fix and a disaster.

First, understand the employer is ultimately responsible. IRC Sections 3402, 3101, and 3111 require employers to withhold and pay employment taxes. Section 7501 requires holding these amounts in trust, with serious penalties for non-compliance.

There’s one escape valve. Under Section 3402(d), if an employer didn’t withhold income tax but the employee paid it anyway, the employer is off the hook for that amount. But only if the employee actually paid.

IRC Section 3509: Relief for Honest Mistakes

This applies when employers misclassify workers without “intentionally disregarding” their withholding duties. If they filed 1099s, the liability drops to:

1.5% of wages for federal income tax
20% of what should have been withheld for FICA

If there are no 1099s, those rates double to 3% and 40%.

The lesson is, always file 1099s for workers you’ve classified as contractors. Even if you’re wrong, it cuts potential liability in half.

Section 3509 won’t help if the employer intentionally ignored the rules, withheld income tax but not FICA, or if the worker is a statutory employee.

In Mescalero Apache Tribe v. Commissioner (2017), the Tax Court ruled the IRS must share taxpayer information with employers in these cases, letting them verify whether workers paid taxes on their 1099 income.

Section 530 Relief: Wiping the Slate Clean

Section 530 of the Revenue Act of 1978 can eliminate employment tax liability entirely if three requirements are met:

Reporting consistency: Timely filed 1099s
Substantive consistency: Didn’t treat similar workers as employees
Reasonable basis: Relied on prior audit, court precedent, or industry practice

The consistency test looks at actual duties rather than job titles. If you treat one delivery driver as an employee and another as a contractor, you’ve got a problem.

Worker-Side Relief

Workers can file Form 8919 to report their share of uncollected Social Security and Medicare taxes. They’ll need a reason code:

A: Received SS-8 determination saying they’re an employee
C: Other IRS correspondence confirming employee status
G: Filed SS-8, waiting for response
H: Received both W-2 and 1099 from same firm

Jeremy offers practical wisdom here. “I’ve actually been involved in situations where I thought my client really should have been treated as an employee. I told them about that, and they were perfectly fine going along with the status quo.” Your job is to inform, not insist. It’s ultimately the taxpayer’s decision.

Form SS-8 requests an official IRS determination. Either party can file it. The IRS gets both sides’ perspectives, then issues either a binding determination or non-binding advisory letter. This isn’t a tax return examination, so normal appeal rights don’t apply, though you can submit additional information for reconsideration.

Your Action Plan

Worker classification isn’t binary. Treating it that way gets practitioners and their clients in trouble.

Key takeaways from Jeremy:

Statutory employees live in a genuine hybrid space. W-2s that report on Schedule C. Business expense deductions that regular employees can’t claim. But keep that Schedule C separate from self-employment income.
Some workers are contractors by law. If real estate agents, direct sellers, and sitter placement services meet the statutory requirements, the common law test doesn’t matter.
Dual status is real. When you see both forms from one company, investigate before assuming error.
Always file the 1099. Getting classification wrong but reporting right cuts liability in half. Skip the 1099, and you double the pain.
Know your relief options. Section 3509 for honest mistakes. Section 530 when there’s reasonable basis. Form 8919 for workers needing FICA credit. Form SS-8 when you need the IRS to decide.

These aren’t rare edge cases. They’re the messy realities that walk through your door regularly. Having command of both the categories and corrections is what makes you indispensable.

For the full technical detail and Jeremy’s classroom-tested explanations, listen to the complete episode. And if you haven’t already, go back to Part 1 for the foundational common law control test. Together, these episodes give you the information you need to answer any worker classification question your practice will face.