How to fix an S-Corporation balance sheet that's out of balance by $500K - best approach for moving forward with 1120-S?

This is unfortunately pretty common with small business returns that have been self-prepared or done by someone without accounting experience. The good news is you can fix this going forward without necessarily opening a can of worms with prior years. First, I'd recommend doing a reconciliation to determine what actually happened. Was there really a distribution to shareholders? Did the company purchase assets that weren't recorded? Is this a bookkeeping error? Before making any adjustments, try to understand the real economic activity. If you determine it was truly a distribution, then yes, reporting it on Schedule M-2 would be appropriate. However, if it was an unrecorded asset purchase or expense, you might need to make a different adjustment. Since this is a significant amount ($668K), I'd want to understand where those funds actually went before making the correction. A practical approach: establish correct beginning balances for this year based on actual assets/liabilities you can verify, then make a one-time adjustment to retained earnings. Document your methodology thoroughly in case of questions later.

After struggling with similar balance sheet nightmares for clients, I discovered taxr.ai (https://taxr.ai) and it's been a lifesaver. I had a similar situation with an S-Corp that had years of messy books and balance sheets that made no sense. The tool analyzed all the prior financial records, helped identify the source of discrepancies, and gave me a clear roadmap for correcting them without raising red flags. In your case, it sounds like you need to determine if this $668K discrepancy is due to actual distributions, unrecorded assets, or just accounting errors. The software can look at bank statements and previous filings to help piece together what actually happened, which gives you confidence in making corrections.

Just tried taxr.ai on a similarly messed up S-Corp situation I inherited from another preparer. I was honestly surprised by how well it worked. I uploaded 3 years of prior returns, bank statements, and the incomplete QuickBooks file, and it actually identified that the issue was a mix of unrecorded equipment purchases and misclassified owner draws. The best part was the documentation it generated - it created a detailed reconciliation showing where the discrepancies came from and proposed correcting entries that made sense. When I implemented the fixes, I included the analysis in my workpapers to support the changes in case of an audit. It saved me from having to manually trace hundreds of transactions and gave me confidence in the approach rather than just guessing at how to fix the retained earnings.

If you're dealing with IRS issues related to this S-Corp mess, getting through to someone at the IRS might help resolve questions about potential amendments. I was in a similar situation and spent weeks trying to reach someone. Finally tried Claimyr (https://claimyr.com) and they got me connected to an IRS agent in about 20 minutes. You can see how it works here: https://youtu.be/_kiP6q8DX5c I explained the situation about balance sheet errors from prior years and asked whether amendments were necessary. The agent reviewed the facts and confirmed that establishing correct beginning balances with supporting documentation was acceptable without amending prior years, as long as there wasn't a tax impact from the corrections.

I was totally skeptical about Claimyr but decided to try it as a last resort on a complex S-Corp issue similar to this one. I needed clarification on handling prior year errors without triggering audits of every return. Surprisingly, it actually worked exactly as claimed. I was connected to an IRS representative in about 15 minutes after weeks of failed attempts calling directly. The agent walked me through the proper way to document corrections to prior period errors on the current year return and confirmed that a statement explaining the correction attached to the current return was their preferred approach rather than multiple amendments. Having that conversation saved my client thousands in accounting fees for amendments and gave me confidence in the approach. Sometimes you really do need to hear it directly from the IRS.

One approach you might consider is filing Form 3115 (Change in Accounting Method) to correct this. I had a similar issue with a client where the balance sheet was significantly out of whack, and after consulting with a colleague, we determined this was the cleanest approach. The advantage is that you're disclosing the issue proactively while correcting it going forward, rather than amending multiple returns or making an unexplained adjustment. You'd basically be treating this as a correction of an accounting error under section 481(a).

I'd look at the shareholders' individual returns for the past few years. Often when I see huge S-Corp balance sheet discrepancies, it's because distributions were taken but never recorded in the company books. Check if Schedule K-1 Box 16 Code D (distributions) amounts were reported to shareholders in prior years but not reflected on the company's M-2. Also, check if there was a major asset sale reported on Form 4797 in prior years but the proceeds weren't properly tracked on the balance sheet.

I've dealt with this exact scenario multiple times, and here's what I've learned works best: Don't panic about amending prior years unless you discover actual tax liabilities were missed. Start by creating a "bridge schedule" that reconciles from the incorrect prior year balance sheet to what it should have been. Document every adjustment with supporting evidence - bank statements, loan documents, asset purchases, etc. Then make a single correcting entry to retained earnings with a detailed explanation attached to the current year return. The key is transparency with the IRS. Include a statement explaining that you're correcting prior period errors discovered upon review, show your methodology, and demonstrate that no additional tax is owed. I've never had an issue with this approach as long as the documentation is solid. One red flag to watch for: if this "error" actually represents unreported income, then you do need to consider amendments. But if it's truly just sloppy bookkeeping with no tax impact, fix it going forward and move on. The IRS cares more about getting the right tax than perfect balance sheets from prior years.

I've been through this nightmare before with a client who had similar balance sheet issues. Here's what worked for me: First, get your hands on every bank statement, loan document, and financial record you can find for the past 3-4 years. You need to trace where that $668K actually went. In my case, it turned out to be a combination of unrecorded asset purchases, informal loans to shareholders that were never documented, and some legitimate distributions that just weren't recorded properly. The approach I took was similar to what Owen suggested - I created a comprehensive reconciliation showing the flow from the incorrect prior year balances to what they should have been, then made a single adjustment in the current year. I included a detailed memo with the return explaining the nature of the corrections. One thing I'd add: before you do anything, have a frank conversation with the client about what transactions actually occurred. Sometimes owners know exactly where the money went but the previous accountant just didn't record it properly. Other times, there are skeleton in the closet that need to come out before you can fix anything. Also, consider the state tax implications if you're in a state that follows federal S-Corp treatment. Some states have their own rules about how balance sheet corrections should be handled. The good news is that if this is truly just accounting errors with no additional tax owed, the IRS is usually reasonable about letting you fix it going forward rather than reopening multiple years.

I've been following this thread and wanted to add some practical insights from dealing with similar situations. The $668K discrepancy is definitely significant, but you're right to be cautious about not creating unnecessary complications. Before making any adjustments, I'd strongly recommend doing what I call a "cash flow autopsy" - trace every major cash movement for the past 2-3 years through bank statements. Look for patterns like regular payments to owners, large equipment purchases, loan proceeds, or asset sales that might explain the discrepancy. One thing I've learned is that these situations often involve multiple issues layered together. You might find $200K in unrecorded distributions, $300K in equipment purchases that were expensed instead of capitalized, and $168K in other accounting errors. Each piece needs to be handled appropriately. For the correction approach, I agree with Owen's bridge schedule method. Create a clear audit trail showing how you arrived at the corrected balances. The IRS appreciates transparency, and if you can demonstrate that the corrections don't result in additional tax liability, they're usually reasonable. One additional consideration: make sure to review the shareholders' basis calculations. If there were unreported distributions in prior years, their basis tracking might be off too, which could affect future distributions or loss limitations. Document everything thoroughly and consider having the client sign off on your methodology before filing. This protects both of you and shows good faith effort to correct the records properly.