An S-corporation election can be involuntarily terminated in two ways. The first way is if the business violates any of the qualifications required of S corporations. So if the business gains more than 100 shareholders, gains a business or nonresident alien shareholder, or enters into a prohibited industry, it will lose its S-corp status. The other way the business may lose its status is if over the past three tax years it derived more than 25 percent of its gross income from passive investment income. Passive investment income is any income that is generated by an activity that the business did not directly participate in. An example of passive investment income is dividends.
Voluntarily terminating a corporation’s S status requires a shareholder vote. Any combination of shareholders who hold at least 50 percent of the outstanding stock must agree to terminate S-corporation status. If a business has a shareholder who owns 51 percent of the outstanding stock, she can compel the business to terminate its S-corp status. The business must then submit a statement to the IRS. This statement must detail the number of shares issued and outstanding as of the vote on the S-corp status. The statement should then identify which shareholders voted to terminate S-corp status and how many shares each owned when the vote was taken. Finally, each named shareholder is required to sign the statement.
Consequences of Termination
The day the business’s S-corp status terminates is when it begins to be taxed as a C corporation. The business then has two tax years: a shortened tax year for when it was taxed as an S corporation with a second return for the remainder of the year when it is taxed as a C corporation. Beyond the complication of preparing two returns and allocating the income and expenses for the year between those two forms, the shareholders may face additional tax burdens. This is because any payment by the business to the shareholder after it loses its S-corp status is taxable to the shareholder. In addition, the business will have to begin to pay taxes on its income beginning with the shortened year's C-corp tax return.
To protect again involuntary termination, an S corporation should do two things. The first is to enter into a shareholders’ agreement. This document gives the S corporation the ability to buy back stock from departing shareholders. The purpose of this agreement would be to minimize the possibility of a departing shareholder's selling his shares to customers that would jeopardize the business’s S-corp status. The second thing to do is to closely monitor the business’s ration of passive income to total income to ensure that the S corp does not earn more than 25 percent of its revenues from passive investment income in three successive years.