Tax In Action

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

Earmark Team · June 1, 2026 ·

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

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

Three Measures, Three Different Questions

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

Retained Earnings: What Happened Over Time

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

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

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

AAA: What Kind of Income

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

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

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

Stock Basis: How Much

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

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

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

Where the Three Ledgers Split Apart

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

Here’s where each ledger lands:

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

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

The specific items that cause divergence aren’t unusual:

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

The Costly Errors That Follow

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

The “Loans to Shareholder” Trap

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

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

Missing Capital Contributions

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

Suspended Losses at Termination

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

The Order-of-Operations Election

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

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

Practical Takeaways for Your Practice

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

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

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

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

Earmark Team · May 31, 2026 ·

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

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

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

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

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

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

Deductible trips include:

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

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

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

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

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

The Strict Substantiation Rules You Can’t Ignore

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

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

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

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

The Depreciation Trap

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

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

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

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

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

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

A Three-Question Framework To Cut Through the Complexity

Wells uses three questions to analyze any vehicle situation:

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

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

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

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

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

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

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

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

The Simpler Alternative: Standard Mileage Rate

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

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

The Bottom Line for Tax Professionals

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

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

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

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

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

Earmark Team · May 15, 2026 ·

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

“Can this be right?” they ask.

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

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

Statutory Employees: The Hybrid Category Most Practitioners Overlook

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

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

The four groups are:

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

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

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

Here’s where it gets interesting for practitioners.

Statutory employees receive a W-2 with box 15 checked. But that W-2 doesn’t go on page one of the 1040 as wages. Instead, it goes on Schedule C as gross income. The worker can then deduct related business expenses. That’s a huge advantage regular employees lost when the Tax Cuts and Jobs Act eliminated unreimbursed employee business expenses.

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

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

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

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

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

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

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

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

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

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

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

The Relief Toolkit When Classification Goes Wrong

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

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

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

IRC Section 3509: Relief for Honest Mistakes

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

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

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

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

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

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

Section 530 Relief: Wiping the Slate Clean

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

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

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

Worker-Side Relief

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

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

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

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

Your Action Plan

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

Key takeaways from Jeremy:

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

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

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

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.