S Corporation

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.

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.