S Corporation

When Good S Elections Go Bad and How to End Them Properly

Earmark Team · January 8, 2026 ·

When businesses elect S corporation status, they often focus on the self-employment tax savings. But what happens when that election no longer makes sense—or worse, when it accidentally terminates? In episode 14 of Tax in Action, tax expert Jeremy Wells, EA, CPA, explores the complex process of ending S corporation elections, based on his firm’s recent experience with businesses struggling in the post-pandemic economy.

“A lot of small businesses that started up during the COVID-19 pandemic have seen business taper off quite a bit in the last year or two,” Wells explains. “Businesses that a few years ago actually made sense to be S corporations, nowadays not so much. And the owners want to stay in business, they want to keep operating, but it can be pretty burdensome to run an S corporation when profit margins aren’t what they were.”

Three Ways Your S Election Can End

Under IRC Section 1362, an S election remains in effect until termination, which can occur in three ways. Wells breaks down each path and the triggers that set them off.

1. Revocation by Choice

The most straightforward way to end an S election is to revoke it voluntarily. “An S corporation can revoke the S election for any taxable year,” Wells notes, “including the first year.”

The process requires shareholders owning at least half of the corporation’s shares (including non-voting shares) to consent in writing. Each consenting shareholder must provide their name, address, tax ID, number of shares owned, the date they acquired the stock, the date their tax year ends, and the corporation’s name and tax ID.

Timing matters. As Wells explains, “The corporation files that revocation statement by the 15th day of the third month of the taxable year. In general, if you’re working with a calendar year S corporation, that’s March 15th.” File after that date, and the revocation takes effect the following tax year.

This creates planning opportunities. “We’ll usually plan to go ahead and close out that calendar year as an S corporation,” Wells says when dealing with mid-year decisions. “But we’ll go ahead and get the paperwork ready and send in that revocation statement and make it effective as of the beginning of the following year.”

Corporations can also file prospective revocations for future dates and even rescind them if circumstances change. However, there’s a catch: if new shareholders join after the revocation is filed, they must also consent to any rescission.

2. Failing to Qualify

The second termination path occurs automatically when a corporation ceases to meet S corporation requirements. Wells emphasizes that “those qualifications have to be met continuously. It’s not just meeting those qualifications, electing S, and then not worrying about it anymore.”

Common disqualifying events include:

Exceeding 100 shareholders
Adding a nonresident alien shareholder
Having a shareholder that isn’t an individual (with limited exceptions for estates, trusts, and tax-exempt organizations)
Creating multiple classes of stock

The stock class issue causes particular confusion. “Voting versus non-voting stock does not create a second class,” Wells clarifies. “You can have voting and non-voting stock in an S corporation.” The problem arises when shares have different rights to distributions or liquidation proceeds.

“In an S corporation, every share of the corporation stock has to confer identical rights to distributions and liquidation proceeds to every other share of stock,” Wells explains. “So if I own 10% of the stock, I get 10% of the distribution. If somebody else owns 20% of the stock, they get 20% of the distributions.”

This is especially important for LLCs electing S status. “If you’re working with an LLC that’s considering electing S, it’s incredibly important to get a copy of the operating agreement, review it, and make sure there are no preferential rights, no waterfall distribution schedules,” Wells warns.

3. Excessive Passive Investment Income

The third termination trigger only affects S corporations with C corporation history. If a corporation has C corporation earnings and profits and generates passive investment income exceeding 25% of gross receipts for three consecutive years, the election terminates.

“Congress intended to make S Corporation provisions available only for businesses that are engaged in active operations of businesses, not those that are mainly involved in passive investment activities,” Wells explains.

The rules here get complex. Passive income includes dividends, interest, rents, royalties, and annuities not earned in the ordinary course of business. However, Wells notes important exceptions. For example, rent from a business actively managing properties doesn’t count as passive if the corporation “performs significant services or incurs substantial costs in the rental business.”

Since many modern S corporations started as LLCs and never operated as C corporations, this rule often doesn’t apply. Wells shares a close call from his practice: “The individual thought he needed to put his individual stock holdings into an LLC and then, for some reason, thought he needed to elect S for that LLC.” The only thing that saved this client was that the LLC had no C corporation earnings and profits.

The Hidden Withdrawal Option

Perhaps the most valuable tool Wells reveals is the withdrawal provision, found in Internal Revenue Manual 3.13.2.27.10.

“If the IRS accepts the withdrawal request, then the entity is treated as if the classification had never been elected,” Wells explains. This option is available only before filing the first S corporation tax return—March 15th for calendar-year corporations.

The withdrawal can be requested through correspondence or by filing Form 8832. Wells has used this for clients who received bad online advice. “We’ve done this before with small businesses that hadn’t even really gotten started yet. The taxpayer got some bad advice online and thought an S corporation starting off was the way to go.”

The advantage is that, unlike revocation, withdrawal doesn’t trigger the five-year waiting period before re-electing S status. “That corporation could elect S, withdraw its election, and then the next year decide to elect S again. And there’s no problem with that,” Wells notes.

When State and Federal Rules Diverge

State administrative dissolutions can come as a surprise to business owners. Many panic when they forget to renew their state LLC registration, but Wells offers reassurance based on multiple IRS Private Letter Rulings.

“The IRS still considers the S corporation in existence. So a state law administrative dissolution of an LLC does not translate into a termination of the S election,” he explains. “As long as the business continues operating and continues fulfilling its tax filing requirements, the IRS doesn’t appear to really care about what happens at the state level.”

There’s no need for a new S election when the entity gets reinstated at the state level. “Just keep operating as if everything is fine, at least at the federal level, and try to get that corporation or LLC reinstated at the state level,” Wells advises.

Critical Documentation and Next Steps

Wells emphasizes the importance of maintaining proper records. Keep the original Form 2553 and the IRS acceptance letter, as you’ll need to know which service center processed the election if you later want to revoke it.

Processing delays have become a challenge. “I’ve seen it take anywhere from six to 18 months for that S election to get processed,” Wells notes, partly because Form 2553 still requires wet-ink signatures and must be paper filed.

This episode is part one of a two-part series. Wells promises to cover the implications of termination, including the five-year rule and handling split years when termination occurs mid-year, in the next episode.

For tax professionals dealing with struggling businesses or succession planning complications, understanding these termination options preserves flexibility for clients whose circumstances change. As Wells demonstrates through his firm’s experience, what made perfect sense during the pandemic boom might need reconsideration today.

Ready to dive deeper into S corporation terminations and their implications? Listen to the full episode of Tax in Action for Wells’ complete analysis and practical guidance for navigating these complex scenarios.

Why S Corporation Elections Backfire More Often Than You Think

Earmark Team · September 5, 2025 ·

Early in his accounting career, Jeremy Wells, EA, CPA, landed what seemed like the perfect client: a newly independent contractor drowning in tax debt to both the IRS and his state agency. Within just a couple of years, Wells helped transform this financial disaster into a success story. Through strategic S corporation planning, proper bookkeeping, and careful tax planning, his client went from owing thousands to receiving small but satisfying annual refunds.

The S corporation election was absolutely the right move. But Wells emphasizes that this was the right client at the right time, with the right circumstances.

In a recent episode of Tax in Action, “S-Corporation Reality Check,” Wells examines the oversimplified advice flooding social media feeds and startup marketing campaigns. While countless online voices promise S corporation elections deliver automatic self-employment tax savings for any successful self-employed person, Wells sees this advice creating expensive problems for businesses that never should have made the election in the first place.

“There’s a cottage industry developing around this concept,” Wells explains. We’re in a perfect storm where remote work and the gig economy have created lots of successful self-employed people who need tax help, but there’s a shortage of qualified advisors who can provide proper guidance.

The reality is, while this cottage industry promises easy self-employment tax savings, the one-size-fits-all approach ignores critical deal-breakers that can transform a supposed tax benefit into a costly mistake.

Balance Sheet Red Flags That Kill S Elections

The cottage industry’s relentless focus on self-employment tax savings completely sidesteps fundamental balance sheet realities that can make S elections counterproductive or even trigger unexpected taxable events.

The most dangerous misconception involves debt basis. Unlike partnerships, where partners receive basis credit for their share of entity debt, S corporation shareholders get no such benefit unless they personally loan money to the corporation.

“I can go get a loan and intend to use the funds in my S corporation, but if I personally guarantee that debt, that is not me generating debt basis,” Wells explains. “I am not loaning money to my corporation.”

This distinction catches many business owners—and their advisors—completely off guard. The COVID-era Economic Injury Disaster Loans are a perfect example of this misunderstanding. Thousands of sole proprietorships took personally-guaranteed SBA loans and later elected S corporation status, only to discover that their EIDL debt provided zero debt basis benefit. When these businesses generated losses, shareholders couldn’t deduct them against other income because they lacked sufficient basis.

But there’s another trap buried in the S election process itself. When an LLC elects S corporation status, the tax code requires a two-step transaction that most people don’t understand. First, the LLC becomes an association taxed as a C corporation, then immediately elects S status. During that first step, a Section 351 exchange occurs where the entity’s assets and liabilities transfer to the new corporation in exchange for stock.

Here’s where it gets dangerous: if the business has liabilities exceeding assets—not uncommon for debt-heavy service businesses with minimal fixed assets—this exchange creates taxable gain. “We might be inadvertently generating a taxable event for that owner or those partners when they make that selection,” Wells warns.

The equity structure challenges run even deeper. S corporations demand a single class of stock, pro-rata allocations of everything, and pro-rata distributions with no exceptions. “All items of income, loss, deduction, gain and credits must be allocated to the shareholders pro rata based on their percentages of ownership in the corporation stock, and there are no exceptions to that,” Wells notes.

This inflexibility is particularly problematic for businesses planning future acquisitions. Many small businesses today are built with acquisition in mind—not just Silicon Valley startups, but local businesses designed to be attractive to buyers within three to ten years. S corporations complicate these plans because many acquisition entities aren’t qualified S corporation shareholders. Non-US entities, partnerships, and C corporations can’t own S corporation stock, forcing expensive workarounds.

This is why Wells always asks clients about their long-term goals: “We always have to plan with the end in mind, especially when it comes to equity.”

Operating Agreements: The Hidden S Election Killers

The S corporation promotion industry systematically ignores a fundamental reality: most operating agreements are legal landmines for S elections. Wells’ firm learned this lesson the hard way, which is why they now require operating agreements from all multi-member LLC clients before making any S election recommendations.

“We read through it and try to pick out these terms and concepts and potential red flags,” Wells explains. What they consistently find are documents written exclusively for partnership taxation under Subchapter K—documents that can directly contradict the rigid requirements of Subchapter S.

The most dangerous provisions involve substantial economic effect requirements under Section 704(b). Partnership operating agreements routinely include liquidation provisions requiring distributions based on positive capital accounts. This creates non-pro-rata distribution requirements that are perfectly normal for partnerships but absolutely prohibited for S corporations.

Wells has encountered operating agreements that explicitly prohibit S elections, containing language like “this LLC will always be a partnership for tax purposes” or “the business cannot do any sort of corporate election.” Even more commonly, he’s seen agreements with waterfall distribution clauses that prioritize some members over others—a structure that violates S corporation pro-rata distribution requirements and can trigger inadvertent election termination.

Perhaps most problematic, Wells notes: “I have never seen an operating agreement in an original draft that listed out what happens if an S election takes place.” Most templates simply don’t consider the possibility, leaving businesses with agreements that actively work against their tax election goals.

Even operating agreements that appear silent on these issues often default to state partnership laws that can require non-pro-rata distributions. “If we have an operating agreement that doesn’t really cover these topics, that’s when state law intervenes,” Wells explains.

The solution requires proactive legal work that the quick-and-easy S corporation services don’t provide. Businesses need either revised operating agreements that explicitly allow for S elections or entirely new agreements written with tax flexibility in mind. This legal work might cost a few thousand dollars upfront, but it’s far cheaper than dealing with an inadvertent election termination that requires a private letter ruling or Tax Court intervention.

The Math Doesn’t Add Up: Hidden Costs and Incomplete Calculations

The S corporation promotion machine focuses entirely on self-employment tax savings while conveniently ignoring every other aspect of a client’s tax situation. This creates problems where businesses make expensive elections based on wildly inaccurate financial projections.

The most glaring flaw involves reasonable compensation requirements. “A lot of the estimates of tax savings with an S election just estimate reasonable compensation way too low,” Wells observes. “Those tax savings are not the result of the S election. Those tax savings are unreasonably low salaries being paid through those S corporations.”

It’s a mathematical sleight of hand. Of course, any advisor can eliminate 100% of self-employment tax by simply not running payroll to active S corporation shareholders. But this isn’t tax planning; it’s setting clients up for IRS problems down the road.

The Section 199A qualified business income deduction creates another calculation error that the cottage industry ignores. Higher reasonable compensation reduces the pass-through income that forms the basis for this valuable 20% deduction. As Wells explains: “We save a little bit of self-employment tax at the expense of a pretty significant deduction for a lot of small business owners.”

For many successful small business owners, losing substantial QBI deductions easily outweighs any self-employment tax savings from an S election.

State and local taxes deliver the knockout punch to many S election projections. Tennessee imposes a 6.5% tax on S corporations. New York City hits S corporations with an 8.85% rate. California charges the greater of $800 or 1.5% of net income. As Wells puts it, “Those taxes can wipe out any projected tax savings from an S election.”

A business owner in Tennessee could save $3,000 in federal self-employment tax only to pay $5,000 in additional state tax. The cottage industry’s federal-only analysis turns a supposed tax benefit into a $2,000 annual penalty.

The complications extend to asset transactions. S corporations create taxable gain when distributing appreciated property to shareholders, which is a problem that partnerships avoid. For businesses holding real estate or other appreciating assets, this difference can cost tens of thousands in unexpected taxes. That’s why Wells generally recommends not holding real estate in an S corporation.

Similarly, S corporations lose access to Section 754 elections that allow partnerships to step up the inside basis of assets when ownership changes. This valuable planning tool helps partnerships minimize taxes when partners sell their interests or inherit them. S corporations simply don’t have this option.

The Professional Alternative to Checkbox Solutions

The problems with S corporation election advice reveal a broader issue: complex tax decisions are being oversimplified into marketing soundbites. While the cottage industry profits from reducing professional judgment to self-employment tax calculators, tax professionals face a choice between participating in this race to the bottom or demonstrating why expertise matters.

“We need to seriously look at what that entity election will mean for the business today, in the future, and for the shareholders or partners themselves,” Wells says. This level of analysis requires understanding balance sheet implications, legal document conflicts, comprehensive tax calculations, and long-term business planning—expertise that can’t be packaged into a simple online service.

When clients arrive demanding an S election because “everyone online says it saves taxes,” the professional response isn’t to immediately comply or dismiss the idea. Instead, walk them through the complete analysis: balance sheet structure, operating agreement provisions, reasonable compensation realities, QBI impacts, state tax consequences, and future business goals.

This educational approach protects clients from expensive mistakes while positioning you as genuinely knowledgeable rather than just another order-taker. It creates long-term relationships built on trust and demonstrated expertise.

While the cottage industry promises simplicity, its oversimplified approach consistently creates far more complexity down the road. Inadvertent election terminations, operating agreement conflicts, unexpected state taxes, and acquisition complications all require costly professional intervention to resolve.

For tax professionals willing to master this complexity, the S corporation election presents both a professional responsibility and a market opportunity. Clients need advisors who can navigate the factors that determine whether an S election truly benefits their specific situation.

Good tax advice requires understanding the complete client situation, not just plugging numbers into a self-employment tax calculator.

To hear Wells’ complete analysis and learn how to position yourself as the thoughtful alternative to the S corporation promotion industry, listen to the full Tax in Action podcast episode where he details the specific questions to ask and analyses to perform that separate professional advice from marketing-driven recommendations.