S Corporation

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.

The Overtime Deduction Just Made the Department of Labor’s Definition of Employee Your Problem

Earmark Team · May 8, 2026 ·

The gig economy has exploded over the past decade. From Fiverr to Uber, from seasonal warehouse workers to freelance accountants, the line between employee and independent contractor has become increasingly blurred. California alone spent years in legal battles over worker classification, with court cases dragging on and state laws changing back and forth.

However, a single worker can legally be an “employee” under one federal law and an “independent contractor” under another for the same work, at the same time. And thanks to the One Big, Beautiful Bill Act, this distinction directly impacts your tax practice.

In Episode 24 of Tax in Action, Jeremy Wells, EA, CPA, tackles this complexity head-on in the first part of a two-part series on worker classification and misclassification. He breaks down exactly how the IRS distinguishes between employees and independent contractors and why tax professionals cannot ignore definitions that come from outside the Internal Revenue Code.

Payroll Taxes Are at the Heart of This Discussion

As Jeremy emphasizes early in the episode, “the tax consequences can be significant for both the employer and the worker.” The gig economy creates opportunities for flexible work, but also leaves workers without employment benefits, fair labor protections, and payroll tax matching.

Payroll taxes are “really the most important aspect of this discussion from a tax perspective,” Jeremy explains. It comes down to who’s responsible for the payroll tax or self-employment tax that results from the money earned.

The stakes are high. Misclassifying a worker can lead to both the employer and worker facing tax liabilities that compound quickly. Get it right, and everyone knows where they stand with FICA, FUTA, and federal income tax withholding.

One Word, Multiple Federal Definitions

For most of our careers, we’ve operated within the comfortable boundaries of Title 26, the Internal Revenue Code. If someone mentioned the Fair Labor Standards Act (FLSA), we knew that was the labor lawyers’ territory. Not anymore.

Jeremy explains that “employee” means different things in different contexts across federal law. There’s a well-established principle that a term should have the same meaning within a single title of the U.S. Code, but it can mean something entirely different when you cross from one title to another.

The Department of Labor uses what it calls the “economic reality test” to determine employee status under the FLSA. This test examines six factors:

Opportunity for profit or loss based on managerial skill
Investments by both parties
Permanence of the relationship
Nature and degree of control
Whether the work is integral to the employer’s business
The worker’s skill and initiative

The key question for the DOL is economic dependence. As Jeremy notes from the DOL’s Fact Sheet 13, “If the economic realities show that the worker is economically dependent on the employer for work, then the worker is an employee.”

The critical distinction is that the DOL explicitly states, “employment under the FLSA is not determined by technical concepts or common law standards of control. It is broader than the common law standard often applied to determine employment status under other federal laws.”

The 2025 Change

Why does this matter for tax professionals? The One Big, Beautiful Bill Act created a new deduction for overtime pay, but it specifically references FLSA Section 7, which deals with employees entitled to overtime compensation.

“An employee who is covered under FLSA Section 7 may qualify for a deduction for part of the overtime payment that the worker earned,” Jeremy explains, highlighting the significance.

This creates an unprecedented situation because “a worker can be considered an employee under FLSA and therefore eligible for potentially deductible overtime, yet not considered an employee for federal employment tax purposes.”

The IRS recognized this gap. In Notice 2025-69, the agency provides guidance on “how employers should report overtime paid to workers who are covered under FLSA Section 7 but are not employees for payroll tax purposes and so won’t receive a W-2.”

The IRS Control Standard: Three Categories That Drive Every Decision

So how does the IRS actually decide who’s an employee? It starts with IRC Section 3121(d), which provides four statutory definitions: common law employees, and corporate officers, certain statutory employees, certain statutory nonemployees.

For most situations, we’re dealing with the common law employee definition. That definition hinges on the common law “right to control” standard, which comes from Supreme Court precedent.

The standard boils down to one question: Does the employer retain the right to direct and control the means and details of the work?

“It’s less about whether the employer actually does control the worker, and more about whether the employer retains the right to control the worker,” Jeremy says, emphasizing a crucial distinction.

An independent contractor, by contrast, is “typically subject to control only as to the desired result, not the means or the methods of doing the work.”

The Evolution from 20 Factors to Three Categories

Courts have spent roughly half a century developing this definition. Key cases include Weber v. Commissioner (1994), Professional and Executive Leasing, Inc. v. Commissioner (Ninth Circuit, 1988), and Simpson v. Commissioner (Tax Court, 1975).

In 1987, the IRS and Social Security Administration compiled 20 factors from court precedents and published them in Revenue Ruling 87-41. Then in 1996, the IRS reorganized these into three categories of evidence in an examiner training manual. Jeremy stresses these are “categories of evidence. They are not themselves legal tests.”

Behavioral Control: The Details and Means of Performance

This category examines whether the employer has “the right to direct or control the details and means by which the worker performs the required services.”

Key indicators include:

Instructions: Jeremy uses a simple example: “If I hire a worker and tell that worker, ‘I need you to produce a widget for me,’ and I don’t tell them anything more than that, then I have given that worker essentially no instruction.” That leans toward independent contractor. But if you specify the tools, timeline, location, and step-by-step process, that leans toward employee.
Evaluation: Monitoring how work is performed (not just the final result) indicates greater control.
Training: Required, periodic, or ongoing training on methods and procedures suggests employment.
Uniforms and branding: These can indicate employment, but Jeremy notes modern realities. “Customer security concerns have led some of these companies to insist that their workers dress up in their uniforms, and have their logos displayed even though they’re classified as independent contractors.”

Jeremy adds a nuance particularly relevant for professionals: “Instructions imposed by the business merely to ensure compliance with customer orders or governmental or governing body regulations may indicate weaker control than more stringent guidelines imposed directly by the business.”

Financial Control: The Economic Aspects

This category looks at “the right to direct or control the economic and business aspects of the worker’s activities.”

Important factors include:

Significant investment: Who provides equipment and pays for large expenditures? Jeremy notes everything is relative. “I run an accounting firm. The biggest equipment expense we have is computers. That’s nothing compared to buying large equipment for a factory.”
Business expenses: “Choosing to incur unreimbursed expenses typically indicates that the worker has the right to direct and control the financial aspects of the business operations.”
Market availability: Can the worker seek other business opportunities? Jeremy emphasizes a critical distinction from the DOL test, citing Nationwide Mutual Insurance Co. v. Darden (Supreme Court, 1992): “The question here is whether the worker has the right to direct and control business-related means and details of the worker’s performance, not whether the worker is economically dependent.”
Method of payment: Guaranteed salary or hourly wages typically indicate employment, though Jeremy notes “plenty of independent contractors, especially freelancers and firms as well, bill for time.”

Relationship of the Parties: Intent Concerning Control

This category examines how both parties perceive their relationship.

Written agreements: These help establish intent, but Jeremy warns, “Just because something’s in writing doesn’t necessarily make it so. We still have to look at the substance of the relationship.”
Incorporation: If a worker operates through a legitimate entity that “follows corporate formalities and has at least one non-tax business purpose,” that generally supports independent contractor status.
Employee benefits: Certain benefits, such as tax-qualified retirement plans, 403(b) annuities, and cafeteria plans, can only be provided to employees. Benefits paid to contractors can often uncover a worker misclassification case. Jeremy is clear: “If we see any of these kinds of benefits, then by definition, we have an employee.”

The S Corporation Officer Trap

Jeremy saves one of his strongest warnings for corporate officers. “Corporate officers are generally considered employees, especially if they are providing services to the corporation.”

For S corporations, this is critical. “An officer of an S corporation that provides services to that corporation is an employee, meaning that individual needs to be paid wages.”

The only exception requires meeting both conditions: the officer provides minor or no services AND is not entitled to receive any pay, directly or indirectly.

Jeremy calls out a common but problematic practice. “One way some tax professionals try to use two wrongs to make a right is issuing a 1099-NEC from the S corporation to that individual. Two wrongs don’t make a right.”

“Even though they both go into Social Security and Medicare, paying self-employment tax is different from paying FICA.” The tax liabilities remain; you’ve just created documentation of the misclassification.

Interestingly, Jeremy notes that one person can legitimately receive both a W-2 and 1099 from the same corporation. “You can have an individual working as an officer for a corporation and as a director for a corporation. That individual’s wages earned as an officer would be reported as wages on a form W-2, and then that individual’s pay as a director would be paid as compensation to a non-employee.”

Most Workers Live on a Spectrum

Jeremy brings us back to practical reality. “In the real world it’s a spectrum. On one end of that spectrum is a pure independent contractor where the employer just says, this is what we want you to do. Now go do it. On the other end, we have an employee where the employer tells the employee exactly how to do every single step.”

Most workers fall somewhere in between. As tax professionals, Jeremy explains, “we might have to make a determination of which end of that spectrum does this worker lean toward more?”

What Comes Next

This episode is part one of a two-part series. In part two, Jeremy will cover what happens when we have a misclassification and what workers and employers can do about that misclassification.

For now, the practical takeaways are:

Learn the DOL’s economic reality test. The overtime deduction depends on it.
Review IRS Notice 2025-69 for guidance on FLSA-covered workers who aren’t employees for tax purposes.
Use the three categories of evidence as your analytical framework, remembering the underlying legal test is the control standard.
Audit your S corporation clients. Officers providing services must be on payroll.
Document substance over labels in all worker relationships.

Listen to the full episode of Tax in Action to hear Jeremy walk through the complete analysis, including all the court cases and regulatory citations that inform these critical classification decisions.

These S Corp Election Mistakes Create Years of IRS Problems

Earmark Team · March 23, 2026 ·

A sole proprietor registers a brand-new LLC, reuses the EIN from their old payroll account, files Form 2553 with an effective date of January 1 (months before the entity even existed) and waits for the IRS to bless the election. What they get back instead is a mess: a new EIN they didn’t ask for, returns filed under the wrong number, and IRS notices piling up about unfiled 1120-S returns. It’s the kind of procedural train wreck that Jeremy Wells, EA, CPA, sees regularly in practice, and it’s entirely preventable.

In this episode of Tax in Action, Jeremy breaks down the S corporation election from start to finish, including the eligibility requirements, the precise mechanics of Form 2553, the framework for late election relief under Rev. Proc. 2013-30, and the analytical rigor required before recommending the election in the first place. The episode is a direct response to the flood of oversimplified S corp content circulating online, much of it from influencers who reduce a major business decision to a single rule of thumb about income thresholds.

In reality, the S corporation election decision is loaded with procedural traps and downstream implications that demand careful analysis. Tax professionals who understand the mechanics of making the election and the full range of factors that determine whether it’s actually beneficial serve their clients far better than those chasing shortcuts.

The episode walks through the procedural mechanics of making the election, the common mistakes that derail it, how late election relief actually works, and what practitioners consistently get wrong about it. Finally, Jeremy digs into why the decision to elect S demands analysis that goes well beyond self-employment tax savings, including ownership structure, balance sheet consequences, QBI deduction impacts, and state and local taxes that can wipe out any benefit entirely.

Getting the election right: The procedural traps that create lasting problems

Before evaluating whether the S election makes sense for a client, you need to know how to actually make it correctly. The requirements look straightforward on paper. In practice, several mistakes can cause problems that last years.

Eligibility

The entity must be a domestic corporation or domestic eligible entity under IRC §1361(b)(1). It can have no more than 100 shareholders, although Jeremy notes he’s never worked with an S corp that came anywhere close to that limit. The overwhelming majority have one, two, maybe three shareholders.

Shareholders must generally be individuals, though certain estates, trusts, and organizations can qualify. Jeremy warns that including an S corp interest in an estate plan can be tricky. There’s a serious risk of inadvertently terminating the election when a trust or estate steps into a deceased shareholder’s place. No shareholder can be a nonresident alien. Basically, shareholders need Social Security numbers.

The eligibility requirement that actually blows elections in practice is the single-class-of-stock rule. An S corporation cannot have shareholders with differential rights to distributions. Voting differences are fine—you can have voting and non-voting shares. However, you can’t have distribution waterfalls, preferred stock arrangements, or any structure in which some owners receive distributions before others. That’s partnership territory. Jeremy points out this issue has been litigated repeatedly in tax court and district courts, with businesses forced to choose between their own governing documents and tax law. The S election usually loses.

The check-the-box shortcut most practitioners still get wrong

Jeremy emphasizes this requirement because many practitioners misunderstand it. An LLC electing S does not file Form 8832 separately. When an LLC files Form 2553, it triggers two simultaneous deemed elections. First, classification as an association (which defaults to C corporation status), and then S corporation treatment. Both happen instantaneously. “Do not file Form 8832 to elect a C corporation first, and then file the 2553. Just file the 2553 to elect S,” Jeremy says.

Filing both confuses the situation and makes a mess. The only time you file Form 8832 for an S corporation is when the entity is revoking its S election and wants to revert to its default classification as a disregarded entity or partnership. Jeremy covers that process in episode 15, Breaking Up with Your S Corp Part Two.

Timing matters, and there’s no extension

Taxpayers must file the election by the 15th day of the third month of the taxable year to be effective for the current year. That’s March 15 for calendar-year taxpayers. Miss that date, and the IRS treats the election as effective for the following year. An election effective January 1, 2026, must be filed by March 15, 2026. File it on March 16, and you’re looking at a January 1, 2027, effective date unless you file for late relief.

Form 2553 details that trip people up

Jeremy identifies several issues drawn directly from situations his firm has handled:

EIN confusion. Electing S does not require a new EIN for an existing entity. That’s Treasury Regulation §301.6109-1(h)(1). But when a sole proprietor forms a new LLC to elect S, that new entity needs its own EIN. You cannot reuse the sole proprietor’s old payroll EIN. Jeremy describes exactly what happens when practitioners try. The IRS accepts the election but assigns a new EIN. The practitioner then files 1120-S returns under the old number. A couple of years later, the IRS sends notices about unfiled returns because nothing was filed under the EIN the IRS actually assigned.
Effective date before the entity exists. The S election effective date cannot precede the entity’s incorporation or registration date. If they formed the LLC in June, the effective date cannot be January 1. Jeremy notes that so many people made this mistake that the IRS printed a caution directly on Form 2553 itself.
Wet ink signatures only. Every signature on Form 2553, including the officer’s on page one and each shareholder’s consent on page two, must be wet ink. No e-signatures. Jeremy acknowledges it’s annoying, but his firm has a workaround: provide the form through a secure portal, instruct the client to print, sign, and scan it back using the portal’s smartphone scanner.
The shareholder consent grid. Page two requires each shareholder’s name, address, tax ID, shares owned, acquisition date, tax year end, and signature, all under a statement that reads “under penalties of perjury.” That language matters, especially for late elections, where shareholders also declare they’ve reported income consistently with S corp status for all affected years.

Even when practitioners know these rules, sometimes the deadline slips. The question then becomes whether late relief is available and whether practitioners should even pursue it.

Late election relief

Late election relief is one of the most discussed (and most misunderstood) aspects of S corp elections. Jeremy sees widespread misconceptions about the process of making a late election, and about whether practitioners should make it in the first place. Before you file anything late, you need to understand the legal framework and the IRS requirements.

The statutory authority starts with IRC §1362(b)(5), which allows the Secretary of the Treasury to treat a late election as timely when the entity has reasonable cause for missing the deadline. Treasury Regulation §301.9100-1 lets the Commissioner grant reasonable extensions for regulatory and statutory elections, and §301.9100-3 extends that to entity classification elections provided the taxpayer shows they acted reasonably and in good faith, and that granting relief won’t prejudice the government’s interests.

Over the years, the IRS issued various revenue procedures for different types of late elections. Rev. Proc. 2013-30 consolidated them into a single document that now governs late S elections, along with electing small business trusts (ESBTs), qualified subchapter S trusts (QSSTs), qualified subchapter S subsidiaries (QSubs), and late corporate classification elections.

The four requirements you must satisfy

Section 4.02 of Rev. Proc. 2013-30 lays out four criteria, and Jeremy stresses taxpayers must meet all four:

The entity intended to be classified as an S corporation as of the effective date. Jeremy calls this “the most important to really nail down.”You can prove intent through board meeting minutes, corporate resolutions, communications with a tax advisor—anything that demonstrates the entity wanted S corp status even though it didn’t file the paperwork on time. The problem is most small business owners don’t keep these records. If your client doesn’t have formal documentation, look for email exchanges with advisors, meeting notes, or other evidence that the intent existed before the deadline passed.
Request relief within three years and 75 days of the effective date. That gives you roughly three years, one month, and 15 days. This is the general window, although there is one exception, which Jeremy covers later.
The only reason the entity doesn’t qualify as an S corporation is the untimely filing. Everything else, including eligibility, ownership structure, and a single class of stock, must be in order. If there’s an underlying eligibility problem, late relief won’t fix it.
Reasonable cause for the failure, plus diligent action to correct the mistake. Jeremy notes the most common explanation is straightforward: owners simply didn’t understand the paperwork or deadlines until a tax professional advised them. There are no strict criteria for what constitutes reasonable cause, and Jeremy has seen various approaches, some successful, some not. The key is being honest and specific about what happened.

The procedural mechanics

You still use Form 2553 to request relief, but with modifications. Print “FILED PURSUANT TO REV. PROC. 2013-30” in all caps at the top of page one. Most tax software has a checkbox that handles this automatically. Include a reasonable cause statement either on the form itself (there’s blank space on the bottom half of page one) or on an attached separate sheet.

If the S corporation has filed all its 1120-S returns for tax years between the effective date and the current year, attach the completed Form 2553 to the current year’s 1120-S, as long as the taxpayer files that return within the three-year-and-75-day window. If there are delinquent 1120-S returns, file them all simultaneously. Jeremy admits this makes him uncomfortable. “I don’t feel good doing that. I don’t like filing that many returns on top of one another.” But he’s done it, and it can work.

His firm’s practice is to fax Form 2553 directly to the applicable IRS service center and attach a PDF to the e-filed return. “It can’t hurt to do it both ways,” he says. Just remember, filing Form 7004 to extend the 1120-S does not extend the deadline for the election itself. There is no mechanism to extend Form 2553.

The exception to the time limit

The three-year-and-75-day window doesn’t apply if all of the following are true:

The entity and all shareholders reported income consistent with S corp status for the year the election should have been made and every year after
At least six months have elapsed since the entity filed its return for the first year it intended to be an S corp
The IRS never notified the corporation or any shareholder of a problem within those six months.

Jeremy stresses this last point. Always make sure clients check their physical mailboxes regularly, because the IRS corresponds about S elections exclusively by mail.

If the entity can’t satisfy Rev. Proc. 2013-30’s requirements, the only remaining option is requesting a private letter ruling from the IRS. PLRs can get expensive, and they’re the last resort rather than a routine tool.

Both the officer signing Form 2553 and each consenting shareholder declare under penalties of perjury that the election is true, correct, and complete. For late elections, shareholders also declare they’ve reported income consistently with S corp status for all affected years. This is a sworn statement the IRS takes seriously.

When the S election is (and isn’t) the right call

This is where the internet’s favorite rule of thumb falls apart. The self-employment tax savings that dominate most S corp conversations are just one variable in a multi-factor analysis. Jeremy identifies several factors that can offset or even eliminate those savings.

Stop relying on rules of thumb

The typical logic goes that if you make more than a certain amount (usually some middle five-figure number), you should elect S corporation status. Jeremy calls these rules of thumb “very dangerous” because they omit critical nuance. Yes, the typical purpose of an S corporation is to replace a larger self-employment tax burden with a smaller payroll tax burden. But that single calculation ignores everything else that changes when you make the election.

Review the ownership structure and the operating agreement

S corporations don’t have the flexibility of partnerships. They don’t allow special allocations, differential distribution rights, or waterfalls. The practical problem is that LLC operating agreements are almost always written from a subchapter K (partnership) perspective, not subchapter S. The partnership language baked into those documents won’t translate well for an S corporation. It can set up owners to inadvertently terminate the election.

Jeremy taught a two-hour webinar for the New York State Society of Enrolled Agents on reviewing LLC operating agreements for non-attorneys. He strongly recommends that practitioners request and review operating agreements before recommending any S election. If you’re not already doing this, start.

Examine the balance sheet before you recommend anything

Unlike partnerships, S corporation shareholders don’t get basis for corporate debt, only for bona fide shareholder loans to the corporation. Personal guarantees don’t count. There are no recourse-versus-non-recourse debt considerations like you’d find in a partnership.

Transferring liabilities in excess of assets into the S corporation as part of the §351 exchange—the corporate transfer that happens when an LLC makes that deemed corporate election—can trigger a taxable event. Appreciated fixed assets, especially real estate, create built-in gains issues, and there’s no §754 inside basis step-up available. Jeremy published a detailed post that walks through corporate transfer accounting.

Don’t ignore what happens to the QBI deduction

Owner wages paid by an S corporation are deductible for the business, which reduces qualified business income. That reduction shrinks the §199A qualified business income deduction. Jeremy has seen cases where the QBI reduction offsets most and sometimes nearly all of the self-employment tax savings. “Essentially, it’s a wash.”

The Election Is Easy. The Decision Isn’t

The mechanics of filing Form 2553 may seem straightforward, but the decision to elect S corporation status rarely is. As Jeremy makes clear, the real work is understanding eligibility rules, avoiding procedural traps, and evaluating whether the election actually improves the client’s overall tax picture.

For a deeper walkthrough of the rules, real-world mistakes practitioners make, and the analytical framework Jeremy uses to evaluate S elections, listen to the full episode of Tax in Action.

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.