Tax Due Diligence Checklist
S-Corporation Tax Due Diligence Checklist
Tax review items for S-corporations. The defining diligence issues are S-election validity, reasonable compensation history, AAA and basis tracking, and the availability of a 338(h)(10) election to step up asset basis.
Why a S-Corporation-Specific Checklist
- •S-elections are surprisingly easy to invalidate (a single ineligible shareholder, a second class of stock issue, a missed eligibility test).
- •Reasonable compensation is the most common IRS adjustment in S-corp examinations and the most common buyer-side discount item.
- •AAA, OAA, and PTI tracking determines whether distributions are tax-free or taxable, and most small S-corps have not maintained these accounts cleanly.
- •A 338(h)(10) election can convert a stock deal into an asset deal for tax purposes — a major price and structure issue.
The Checklist
Items a buyer or seller in a s-corporation transaction should expect to request, produce, or review.
1. S-Election Validity
Confirming the S-election is and always has been valid is the threshold question. An invalid election means the entity was a C-corp, with retroactive C-corp tax and double taxation exposure.
Form 2553 (original S-election) and IRS acceptance letter
Date filed, effective date, and IRS confirmation. If acceptance letter is missing, request transcript or copy from IRS.
Eligibility analysis at election and continuously since
Number of shareholders (under 100), all eligible (US individuals, certain trusts and estates, no partnerships or corporations), one class of stock, no nonresident aliens.
Single class of stock review
Buy-sell agreements, employment agreements, debt instruments tested for whether they create disproportionate distribution rights or a second class of stock.
Inadvertent termination history
Any events that may have terminated the election (excess passive income, transfer to ineligible holder), and any IRS waiver or relief obtained under Section 1362(f).
QSST and ESBT trust elections
If trusts are shareholders, copies of QSST/ESBT elections and ongoing compliance.
QSub elections for subsidiaries
Form 8869 for any qualified subchapter S subsidiaries, with eligibility verification.
2. Reasonable Compensation
The IRS challenges S-corps that pay shareholders low W-2 and high distributions. This is the single most common adjustment in S-corp examinations.
W-2 history for each shareholder-employee by year
Compensation amounts, distributions, and ratio of compensation to distributions.
Job description and time commitment for shareholder-employees
Hours worked, services performed, and qualifications.
Industry comparables and benchmarking
Salary surveys (BLS, RC Reports, or industry-specific sources) supporting reasonableness.
Trend analysis
Sharp shifts in W-2 to distribution ratio, especially when revenue or profitability did not change.
Section 162-style factor analysis
Training, experience, role, complexity, comparison to non-shareholder employees doing similar work.
Payroll tax filings (Form 941, 940, state UI) for last 4-6 years
Reconciled to W-2 amounts on returns.
3. AAA, OAA, and PTI Tracking
Distributions are non-taxable to the extent of AAA but taxable when AAA is exhausted and the entity has E&P from C-corp years. Many small S-corps do not maintain these accounts.
AAA roll-forward by year since S-election
Beginning balance, increases (S-corp income), decreases (distributions, deductions), and ending balance.
Accumulated E&P from any prior C-corp period
If the entity was ever a C-corp, retained earnings as of the last day of C-corp existence.
OAA (other adjustments account) tracking
Tax-exempt income flowing to and out of OAA.
PTI (previously taxed income) for pre-1983 elections
Rare but should be confirmed for older S-corps.
Distribution ordering analysis by year
Each year's distributions traced through AAA, AE&P, OAA, and basis.
Section 1368(e)(3) elections
Election to distribute E&P first, if made.
4. Shareholder Stock and Debt Basis
Per-shareholder stock basis schedule
Initial basis at acquisition, increases (income, contributions), decreases (distributions, losses), and current basis.
Debt basis from direct shareholder loans
Loans from shareholders directly to the corporation (not loans guaranteed by shareholders).
Loss limitation history
Losses suspended at the basis limitation and carried over.
Form 7203 if filed (basis reporting)
IRS reporting form for shareholder stock and debt basis since 2021.
5. Built-in Gains Tax (Section 1374)
S-corps that converted from C-corp are subject to BIG tax on appreciation that existed at conversion if recognized within five years. Always check this for converted entities.
Date of S-election and conversion analysis
If converted from C-corp, the conversion date and the five-year recognition period.
Net unrealized built-in gain at conversion
Asset-by-asset fair value vs. basis at conversion date.
Recognized built-in gains by year since conversion
Asset dispositions during the recognition period and BIG tax paid.
BIG basket remaining
Net unrealized built-in gain not yet recognized, with current limitation analysis.
6. Excess Passive Income (Section 1375)
Passive investment income testing
If S-corp has E&P and passive investment income exceeds 25 percent of gross receipts for three consecutive years, the S-election terminates and 1375 tax applies in the meantime.
Composition of investment income
Royalties, rents, dividends, interest, annuities tested by year.
7. 338(h)(10) Election Analysis
A 338(h)(10) election treats a stock sale as an asset sale for tax purposes. It is one of the most consequential structuring decisions in any S-corp acquisition.
Eligibility for 338(h)(10) election
S-corp target, qualifying stock purchase, eligible buyer, and consent of all shareholders.
Purchase price allocation modeling
Allocation among Class I-VII assets, with effect on seller character (ordinary vs. capital) and buyer step-up.
Tax cost comparison: stock sale vs. 338(h)(10)
Side-by-side modeling of total tax in each scenario.
Purchase price gross-up analysis
Whether the buyer compensates the seller for additional tax cost of 338(h)(10) treatment.
F-reorganization alternative
If 338(h)(10) is not available or optimal, F-reorg structure to achieve similar economics.
8. Federal Returns and Open Items
Form 1120-S for last 4-6 years with all schedules and K-1s
Complete returns and K-1s for all shareholders.
M-1, M-2, and Schedule L for each year
Reconciliation of book to tax, AAA tracking on Schedule M-2, and balance sheet.
Section 163(j) interest expense computation
If applicable to the S-corp.
Section 199A QBI tracking
Per-shareholder W-2 wages, UBIA, SSTB classification.
ERC and other COVID-era credit positions
Original claims, supporting analysis, and any IRS correspondence.
IRS audits and notices for last 6 years
Including any 1374 examinations specifically.
9. Multi-State and Local
State income and franchise tax returns by year
Including any states that do not recognize the federal S-election (which then taxes at corporate level).
Composite returns for non-resident shareholders
By state, by year.
Pass-through entity tax (PTET) elections
By state and year.
Sales and use tax (Wayfair compliance)
Highest exposure area for most small businesses.
10. Payroll, Worker Classification, and Benefits
1099-NEC issuance history
Total 1099 spend, contractor agreements, classification analysis.
Health insurance for 2-percent shareholders
Treatment of health premiums on W-2 (must be included for above-the-line deduction).
Retirement plan compliance
Form 5500 filings, top-heavy testing, owner-only or otherwise.
Section 105 medical reimbursement plans
If applicable.
Frequently Asked Questions
What is the most common tax issue found in S-corp due diligence?
Reasonable compensation. Most closely-held S-corps pay the owner-employee a salary that is too low relative to the services they perform, with the rest taken as distributions to avoid payroll tax. The IRS challenges this regularly and a buyer's diligence will price in the exposure. Either fix it before going to market or expect it to come up in negotiation.
What is a 338(h)(10) election and when does it make sense?
A 338(h)(10) election lets the parties treat a stock sale as if it were an asset sale for federal tax purposes. The buyer gets a stepped-up basis in the assets (real depreciation value over time), while the seller pays tax as if they sold assets. For most S-corp deals where the seller's tax outcome is similar either way, the buyer's basis step-up is real value, often justifying a price gross-up to the seller. It is only available in specific circumstances (S-corp target, qualifying stock purchase, all shareholders consent).
What is built-in gains tax (Section 1374)?
Section 1374 is a corporate-level tax that applies when an S-corp converts from a C-corp and then recognizes built-in gains within five years of conversion. It exists to prevent C-corps from making an S-election as a tactic to avoid double taxation on appreciated assets. For any S-corp that converted from C, the built-in gains schedule is a critical diligence item.
Can my S-election be invalid without me knowing it?
Yes. The most common ways are: a transfer to an ineligible shareholder (corporation, partnership, nonresident alien, certain trusts), creation of a second class of stock through a buy-sell or compensation arrangement, or excess passive income for three consecutive years if the S-corp also has C-corp E&P. The IRS allows relief in many cases under Section 1362(f), but the relief is not automatic and requires a showing.
How is AAA different from retained earnings?
AAA (Accumulated Adjustments Account) is a tax-only account that tracks income that has already been taxed at the shareholder level under the S-election. Distributions out of AAA are tax-free; distributions in excess of AAA may be taxable as dividends if the corporation has accumulated C-corp earnings, and otherwise reduce stock basis. Retained earnings on the books is a financial accounting concept that does not perform any tax function. Many small S-corps confuse the two.
Pillar Pages
Sell-Side Tax Due Diligence
For family business owners going to market. Surface and fix tax exposures before a buyer finds them and discounts your price.
Buy-Side Tax Due Diligence
For small businesses growing through acquisition. Understand what you are buying, who carries the exposure, and how to structure the deal.