How would you know if they made this election? Is there specific paperwork they would have?

They should have filed Form 8832 (Entity Classification Election) and/or Form 2553 (Election by a Small Business Corporation) with the IRS if they made that choice. Ask your client if they ever filed these forms or received confirmation of S-Corp status from the IRS. Most small business owners remember making this election because it's a significant tax decision that usually involves discussing it with a tax professional first. They'd also have been filing very different tax forms in previous years - Form 1120-S instead of just including a Schedule C with their personal return. Plus, if they were an S-Corp, they should have been paying themselves a reasonable salary with payroll taxes.

Omg yes this! I had a client put all their rental property repairs on the same credit card as their other business expenses and sorting it out took FOREVER.

Thanks for bringing this up! I hadn't considered the basis issue. Do you recommend any specific tracking method for keeping tabs on this throughout the year? Is this something I should be having my bookkeeper monitor?

Your bookkeeper should definitely be tracking this if they're familiar with S corporations. The simplest method is to maintain a basis worksheet or schedule that gets updated with each capital contribution, income/loss allocation, and distribution. QuickBooks and other accounting software don't automatically track S corp basis, so you'll need a separate spreadsheet or basis tracking tool. Some tax preparation software includes basis worksheets that you can update throughout the year. The key is documenting everything contemporaneously rather than trying to reconstruct it at year-end.

There's no rules about timing for tax purposes since the income is passed through to you regardless of when distributions happen. But practically speaking, many accountants recommend keeping distributions somewhat proportional to your salary throughout the year rather than taking one massive distribution and small salary. Looks less suspicious if you get audited.

Thanks for sharing your experience! That's really helpful to know someone else has been through this exact situation with Fidelity. I'm planning to follow the same approach you did. Just to confirm - did you include any special notes or attachments with your 2020 return to explain why you were including additional wage income that didn't match your W-2? Or did you just add it to Line 1 without further explanation?

I added the excess amount directly to Line 1 on my 1040 for 2020. My accountant also included a statement with the return that briefly explained the situation - basically noting that we were reporting excess 401(k) deferrals returned in 2021 as 2020 income per Publication 525. For my 2021 return, we included a more detailed statement explaining why we were reporting the 1099-R with code P but also including the offsetting negative entry. The key is making sure there's a clear paper trail showing you handled it correctly and aren't double-reporting or missing income.

Yes, it's handled quite differently after April 15th! If excess deferrals aren't distributed by April 15th of the year following the year of deferral, you end up with a serious tax headache. In your case, those excess contributions are now essentially "double taxed." They'll be included in your taxable income for the year contributed (2020) AND again when they're eventually distributed from the plan. Additionally, they're still sitting in your 401(k) where they're not supposed to be, which could potentially lead to a 6% excess contribution penalty each year until corrected. You should contact your plan administrator immediately to request a distribution of the excess amount, even though it's late. Some penalties might still apply, but getting it corrected now is better than leaving it uncorrected.

I tried this approach last year but got burned by wash sale rules when I tried to buy back similar investments after selling for losses. Any tips on avoiding that pitfall while still maintaining market exposure?

The key to avoiding wash sale issues is to sell investments at a loss and then buy something similar but not "substantially identical" to maintain your market exposure. For example, if you sell an S&P 500 index fund from one provider at a loss, you could immediately buy an ETF that tracks a different but similar index (like a total US market ETF) to maintain similar exposure without triggering wash sale rules. Another approach is to use the 31-day waiting period strategically. You could sell the underwater investment, move temporarily into a broader market fund for 31 days, then move back into your preferred investment afterward. The temporary investment gives you market exposure during the waiting period. This works well if you're rebalancing anyway or if you're willing to accept a slightly different allocation for a month.

This is actually a really important point that many people miss. It depends heavily on your investment timeline and the performance difference between your current funds and the ETFs you're considering. If your active funds consistently outperform the ETFs by even a small margin, that could outweigh the tax efficiency advantage.

Thanks for the advice! I didn't even think about documenting the physical location. I'll definitely take pictures next time my parents go there. Do you know if there's a way to check if someone has a valid PTIN? I looked at the paperwork again and don't see any ID number for the preparer.

There's no public database where you can verify PTINs unfortunately. If the preparer didn't include their PTIN on the return where it asks for "Paid Preparer's Information," that's a violation of IRS requirements right there. Take photos of the office exterior, interior if possible, and any signage showing the business name. If they have a website or social media presence, screenshot those too - these operations sometimes disappear overnight when they get reported. Also, if your parents paid by anything other than cash, that bank or credit card statement is valuable evidence of them using this service.

Did your sister end up reporting the preparer too? Just curious if anything actually happens to these people when they get reported or if they just keep scamming others.