The Termination of S Corp Status

By John Cromwell

S corporation status is an IRS-sanctioned tax designation that allows a corporation to retain liability protection for its shareholders but lets them be taxed like a partnership.This means that the S corporation is not taxed directly, but its shareholders add their share of the business’s annual income and losses to their personal returns and personally pay taxes on those amounts. To choose this status, the corporation must have fewer than 100 shareholders and cannot have any nonresident alien shareholders. It can only have one class of stock and cannot participate in certain industries. A corporation can have its S-corp status rescinded by the IRS or its shareholders can choose to give it up.

Involuntary Termination

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.

Voluntary Termination

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.

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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.

Considerations

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.

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When Can I Revoke an Election in an S Corporation?

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S Corporation Structure

An S corporation is a tax designation that a business must apply for with the Internal Revenue Service. Used for small businesses, the benefit of the S corporate designation is that it allows the business to be taxed as a partnership. To apply for S corporate status, the business must submit a completed Form 2553 within 2 months and 15 days after the beginning of the first tax year that it wants to be treated as an S corporation.

How Is Passive Income Taxable to an S Corporation Shareholder?

A chief benefit of being an S Corporation is that it allows the corporation’s shareholders to be taxed directly on all income earned by the business. Owners benefit from direct taxation because a C Corporation's profits are taxed twice: once when earned by the corporation and again when distributed to the owners as a dividend. When an S Corp shareholder pays taxes on the business’s income, the funds are broken down based on how the S Corp earned the money. As a result, a shareholder may pay different tax rates on different portions of her S Corporation’s income. One aspect of S Corporate income that may be taxed differently is the business’s passive income.

What Are All the IRS Filings for an S Corp?

A "C" corporation is a standard corporation, while an "S" corporation has elected a special tax status with the IRS, allowing it to be taxed as a flow-through entity that passes its income through to its shareholders instead of filing a return in its own name and paying taxes at the corporate rate. To ensure that the IRS receives taxes on that income, however, it strictly limits the number and type of shareholders that an S corporation can have. The IRS filings to elect, maintain and terminate S corporation status are specific because the IRS requires proof that the corporation and its shareholders are eligible for S corporation tax treatment.

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