S Corporation Elections: The 4 Ways Your S Status Can Break (and How to Fix It Before It Gets Expensive)

Electing S corporation status can be a smart move for the right business — but the election is fragile. One missed procedural step or eligibility issue can cause your S election to be invalid from day one or terminate immediately, often without you realizing it.

Below are the four most common failure points, plus real-world examples and CPA callouts so you know exactly what to look for — and how to fix problems before they become an expensive IRS letter ruling situation.

CALL-OUT: Why this matters (even if you’ve “filed 1120-S for years”) A tax return being accepted is not the same as your S election being valid.

The problems most often surface during bank financing, buy/sell negotiations, divorce/estate planning events, or business sale due diligence — when someone finally asks for the election paperwork and governing documents.

The S-Corp “Break Points” (Fast Overview)

CALL-OUT: The 4 biggest S election traps LLC operating agreement accidentally creates a second class of stock The Form 2553 was late (or never actually filed) A trust shareholder becomes ineligible (or a QSST/ESBT election is missed)

Missing shareholder consents — especially spousal consents in California/community property states

Problem 1: Your LLC operating agreement accidentally creates a second class of stock

This is one of the most common “silent” problems I see when a state-law LLC elects S corporation taxation.

Why it happens

S corporations can have voting and nonvoting stock, but they must have one economic class of stock — meaning identical rights to distributions and liquidation proceeds.

The IRS doesn’t just look at what you actually distributed. They look at what your governing provisions say you could do, including:

• LLC Operating Agreement

• Shareholder agreements

• Buy-sell agreements

• Side agreements tied to distributions or liquidation

Many operating agreements were written for partnership taxation and include capital account / liquidation provisions intended to comply with partnership rules — language that can become toxic once you elect S status.

EXAMPLE: The “capital account liquidation” landmine An LLC elects to be taxed as an S corporation, but its operating agreement still says that upon liquidation, assets will be distributed based on “capital accounts” maintained under partnership rules. Even if the LLC has always distributed profits 50/50, the agreement can create non-identical liquidation rights — risking an invalid election.

CALL-OUT: The “we distributed pro-rata, so we’re fine” mythMany owners assume the IRS only cares whether distributions were proportional. In many cases, the IRS focuses first on what your documents allow, not just what you did.

EXAMPLE: The “state tax true-up” side agreement Two shareholders agree (in writing) that the owner living in a higher-tax state gets a larger distribution to “true up” state taxes. If that agreement is binding, it can create a second class of stock and terminate S status.

What to do (practical fix)

• Review your operating agreement (and any shareholder agreements) for S-corp compliance

• Remove partnership-style liquidation language and special allocation mechanics

• Document the correction and keep it in the permanent file

CPA CALL-OUT (California LLCs): California owners often do LLC → S-corp for payroll tax planning. That’s fine — but the operating agreement must be updated. Otherwise, the entity can look like an S-corp on paper… until a buyer’s diligence team reads the agreement.

Problem 2: Late S elections (or the election was never filed)

This is more common than most business owners realize.

Why it happens

• The CPA prepared Form 2553 but it never got filed

• A new business started operations before the election was submitted

• Ownership changed and nobody tracked the deadline

• An LLC changed classification and the timing got missed

EXAMPLE: “We assumed the prior CPA handled it” A business has filed Form 1120-S for 6 years. In year 7, a new CPA requests the signed Form 2553 for due diligence prep — and no one can find it. If the IRS doesn’t have a valid election, the entity may have been a C corporation all along (at least technically), even if returns were accepted.

CALL-OUT: The deadline owners miss If you want S status effective January 1, the election is generally due by March 15 (calendar-year entities). New entities can have different “first year” timing depending on when they first had shareholders, assets, or business activity.

What to do

• Confirm the IRS has a valid election on file

• If it was late or missing, pursue the IRS relief procedure before time windows close

• Keep a PDF copy of the signed Form 2553 in your permanent records

Problem 3: Trust shareholders become ineligible (or QSST/ESBT elections are missed)

Trust ownership is a major S-corp danger zone.

Why it happens

Only certain trusts can be S-corp shareholders — and some require additional elections (QSST or ESBT) with strict timing rules.

Common triggers:

• Death of an owner → trust status changes

• Estate planning transfers

• A grantor trust “turns off” grantor status

• The QSST/ESBT election simply wasn’t filed on time

EXAMPLE: The “post-death two-year clock” An owner dies and their trust holds S-corp stock. Some trusts can remain eligible for a limited period (often two years), but once that grace period ends, you may need a QSST or ESBT election. If the election isn’t made in time, the trust becomes an ineligible shareholder — and the S election can terminate.

CALL-OUT: The trap in family wealth + business planning A perfectly designed estate plan can unintentionally break an S election if the trust elections aren’t filed on time. Estate attorneys often draft the trust. The CPA is usually the one who has to keep the S-corp election alive.

What to do

• Maintain a trust ownership checklist

• Store: the trust, trustee info, beneficiary info, and any QSST/ESBT elections

• Put election deadlines on a compliance calendar

• Review trust status after any life event (death, divorce, remarriage, incapacity planning)

Problem 4: Missing shareholder consents (California/community property trap)

S elections require shareholder consents — and identifying “who must consent” is where things break.

Why it happens

• Election is retroactive and prior-year shareholders aren’t included

• Trust/estate signature done by wrong person

• Spousal consent missing in community property states (including California)

EXAMPLE: Retroactive election requires “former shareholder” consentA, B, and C owned shares on January 1. A sold shares to D in February.The company files an S election in March effective January 1.A still must consent, because A was a shareholder during the retroactive period.

EXAMPLE: California spouse consent problemHusband owns the shares in a California business.Because CA is a community property state, the spouse may be treated as having a community interest — and the spouse’s consent may be required for a valid election, even if only one spouse appears on the stock records.

CALL-OUT: This is one of the most preventable S-corp failuresThe fix is usually a clean documentation process: stock ledger + signed consents + spouse review when applicable.

What to do

• Verify all required consents were obtained

• Confirm spouse consent rules when owners are married in CA or other community property states

• If a consent is missing, pursue the correct IRS relief procedure promptly

The Due Diligence Moment: When this becomes a real financial problem

CALL-OUT: When S-election defects become expensive Most owners discover problems when: selling the business bringing in partners/investors applying for a loan undergoing divorce/estate planning transfers the buyer’s CPA/legal team requests proof of S status

A buyer may require:

• escrows or holdbacks

• indemnities

• price reductions

• delayed closing until the issue is cured

S-Corp “Health Check” Checklist (what I do for clients)

CALL-OUT: The 6-document S-corp file you should have ready Executed Form 2553 (signed + dated + complete) Proof of required consents (including spouses if applicable) Operating agreement / bylaws / shareholder agreements (reviewed for one-class-of-stock) Stock ledger + ownership change documentation Trust documents + QSST/ESBT elections (if applicable) Support for any corrective filings / relief requests

Work with a California CPA who treats entity elections like infrastructure

If you’re operating as an S corporation - or considering the election talk to a tax professional with expertise in working with s corporation shareholders and new and existing shareholders

• confirm your election is valid and “diligence-ready,”

• fix common defects using the appropriate IRS relief paths (when available), and

• align your entity structure with California realities (community property, payroll, compliance, and planning). We can help. Let's get our conversation started.

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About us

Natalie C. Papagni, CPA – Tax, Planning and Advisory Services

provides tax, planning and advisory services to individuals and high-income earners, physicians and healthcare professionals, business owners - entrepreneurs and new and existing businesses and private practices serious about saving taxes and minimizing multi-year tax liabilities, filing accurate and efficient tax returns, transforming financial complexity into clarity, planning for their financial future and achieving what matters most.

Natalie C. Papagni, CPA

Tax, Planning and Advisory Services

4727 Executive Drive Suite 300

San Diego, CA 92121

858.754.8277

service@lajollataxcpa.com

www.lajollataxcpa.com