Does Selling 100% of Stock Terminate an S Corporation?

By John Cromwell

One way to acquire an S corporation is to purchase all of its stock. When the entirety of a business’s outstanding stock is acquired by a single entity, some may question whether the S corporation is terminated. The acquisition would not cause the business to lose its corporate status, but depending on what entity purchases the corporate stock, the business may lose its S corporate status.

Definition of an S Corporation

An S corporation is actually a tax status granted by the IRS that allows a corporation to be taxed as a partnership. To qualify for S corporate status, the business must have fewer than 100 shareholders who are all individuals, estates, exempt organizations or certain trusts. Corporations and partnerships cannot be shareholders in an S Corporation, nor can nonresident aliens. S corporations can only have one class of stock. Banks, insurance companies, and domestic international sale corporations cannot qualify for S corporate status.

Corporate Stock Acquisition

A corporation is an independent entity from its owners, known as shareholders. This independence is what provides the shareholders protection from the business’s liabilities and enables them to easily transfer their shares when they want to exit the business. As a result, the act of selling all the stock to one entity is not enough to terminate a corporation.

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Involuntary S Corporation Termination

Depending on how the transaction is structured, the sale of 100 percent of an S corporation's stock can cause a loss of tax status. Any violation of the S corporation's qualifications as defined by the tax code will cause a corporation to automatically lose its tax status. If another corporation, a partnership, or a nonresident alien shareholder acquires its stock, it will no longer be an S corporation.

Consequences of Termination

If the stock acquisition causes the S corporation to lose its tax status, it must be taxed as a C Corporation as of the date of the transaction. The business must file two tax returns with the IRS the year of the transaction. The first tax return covers the period from the beginning of the year to the day before the transaction. During that period, the corporation is taxed as an S Corporation and the business will need to file an 1120S with the IRS. The second tax return covers the period from the day of the transaction until the end of the year. During that period, the corporation is taxed as a C Corp and the business will file Form 1120.

Voluntary Termination

A person who acquires an S corporation can terminate its tax status if she chooses. The new owner must draft and submit a statement to the IRS stating her intent to terminate S corporate status. The new owner must send the statement to the address found in the Instructions for IRS Form 2553. This statement must show that the owner controls the entirety of the S corporation’s stock and that as sole owner she wants to terminate the corporation’s tax status. She must then sign the statement.

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The Termination of S Corp Status
 

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How to Change the Shareholders' Percentage in an S-Corporation

An S-corporation is a flow through tax entity; its shareholders are taxed on their shares of the business’s income and losses, while the business itself does not have to pay income tax. A shareholder’s percentage in any corporation is the amount of shares she owns divided by the total number of shares outstanding. Therefore, to change a shareholders’ percentage, you must adjust how many shares the shareholder controls, or adjust the amount of outstanding stock.

Switching Ownership of the S Corp

An S corporation begins its life as a regular corporation. At some point after creation, the corporation makes a Subchapter S election with the Internal Revenue Service for special tax treatment. To be approved, the corporation must meet the IRS eligibility requirements. S corporations remain subject to the laws of the state as they apply to all corporations, including laws on transfers of ownership. If the change in ownership destroys its IRS eligibility, the corporation will automatically lose its S corporation status.

How to Dissolve an S-Corp but Keep an LLC

Businesses that can become an S corporation are limited to corporations and entities that can choose to be taxed as corporations, such as limited liability companies. An S-Corp is a business with a special tax status that allows its shareholders to include the business' profits and losses on their personal returns. In exchange, the IRS does not tax the business itself. An LLC is formed under state law, which is distinct from federal tax law. When an LLC elects to be taxed as an S-Corp, it remains an LLC in every respect, except for taxation. Therefore, when a business terminates its S-Corp standing with the IRS, this will not affect its standing as an LLC.

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