TERMINATION OF S CORPORATION ELECTION
    1. Effect of S Corporation Election.
      1. Once an S corporation election is made, it continues in effect for all succeeding taxable years unless the election is terminated (§ 1362(c)).
    1. Termination of S Corporation Election.
      1. An S corporation election can be terminated in any of the three following ways:
        1. Revocation - The election may be revoked if shareholders owning more than one-half of the corporation's stock (including nonvoting stock) consent to the revocation (§ 1362(d)(1)(A) & (B)).
          1. A revocation made by the 15th day of the third month of the corporation's tax year is retroactive to the first day of the tax year of revocation (§ 1362(d)(1)(C)(i) and Reg. § 1.1362-2(b)(2)).
          1. A revocation made after the 15th day of the third month is effective on the first day of the following taxable year (§ 1362(d)(1)(C)(ii) and Reg. § 1.1362-2(a)(2)).
          1. The revocation may specify a prospective effective date (§ 1362(d)(1)(D) and Reg. § 1.1362-2(a)(2)).
          1. A person becoming a shareholder after the election is bound by the initial election unless that shareholder owns more than one-half of the voting stock of the corporation, in which case, the shareholder, whether or not he is a new shareholder, has the power to revoke the election.
          1. The revocation is made by the corporation by filing a statement that the corporation revokes the election made under § 1362(a). The statement must state the number of shares of stock that are issued and outstanding at the time the revocation is made. For revocations which specify a prospective revocation date, the statement must indicate the date on which the revocation is intended to be effective. The statement must be signed by any person authorized to sign the return required to be filed under § 6037 and must be filed with the Service Center with which the election was properly filed. In addition, there must be attached to the statement of revocation, a statement of consent, stating the name, address, and taxpayer identification number of each shareholder who consents to the revocation, and the number of issued and outstanding shares of stock (including nonvoting stock) held by each shareholder (whether consenting or not) at the time of the revocation. The statement must be signed by each shareholder who consents to the revocation (Reg. § 1.1362-6(a)(3)).
        1. Ceasing to be a Small Business Corporation - An election is terminated if at any time after the first day of the first taxable year of the corporation for which the election is effective, the corporation ceases to be a small business corporation (§ 1362(d)(2)(A) and Reg. § 1.1362-2(b)).
          1. For example, if any of the corporation's stock is acquired by a nonresident alien, a nonqualified trust, another corporation, a partnership, more than the permitted number of shareholders, or if more than one class of stock is issued, the corporation will cease to be a "small business corporation" under § 1361(b) (Reg. § 1.1362-2(b)).
          1. An S corporation will cease to be a small business corporation if it has more than one class of stock issued and outstanding.
          1. If the election is terminated in this manner, the termination is effective on the date the corporation ceases to be a small business corporation (§ 1362(d)(2)(B) and Reg. § 1.1362-2(b)(2)).
            1. If a corporation makes an election to be an S corporation which is to be effective beginning with the next taxable year, and fails to meet the definition of a small business corporation on the first day of such taxable year, its election will be treated as having been terminated on such first day.
            1. If a corporation meets the definition of a small business corporation on the first day of its taxable for which the election is effective, there is no termination of its election as a result of the failure to meet such definition at any time during the period beginning after its election and before the first day of such year (Reg. § 1.1362-2(b)(2)).
              4) In the event of a termination due to the corporation ceasing to be a small business corporation, the corporation is required to immediately notify the Service Center with which the election under § 1362(a) was filed. Such notification must set forth cause of the termination and the date thereof. In addition, if the termination was caused by the transfer of stock to a 36th shareholder, to a nonresident alien, or to an ineligible trust, partnership, or corporation, the notification must specify the number of shares transferred to such person, the name of such person (or in the case of a trust, the names of the trustee and beneficiary), and the name of the shareholder who transferred such stock to such person. If the termination was caused by the issuance of a second class of stock, the notification must indicate the number of shares of such new class issued and must describe the differentiating characteristics of the new class of stock (Reg. § 1.1362-2(b)(1)).
        1. Failing Passive Income Test for 3 Years - An election is terminated if the corporation has passive investment income that exceeds 25% of gross receipts for three consecutive S corporation taxable years and the corporation has subchapter C earnings and profits at the close of such taxable year (§ 1362(d)(3)(A)(i) and (iii) and Reg. § 1.1362-2(c)).
          1. The three-year period only includes taxable years beginning after December 31, 1981, where the corporation was an S corporation (§ 1362(d)(3)(A)(iii)).
          1. The termination is effective as of the first day beginning after such third consecutive year (§ 1362(d)(3)(A)(ii) and Reg. § 1.1362-2(c)(2)).
          1. An S corporation without subchapter C earnings and profits can have unlimited passive income without terminating its election.
          1. An S corporation with subchapter C earnings and profits can have passive income exceeding the 25% limit for two consecutive years without losing its election. The S corporation, however, may be subject to tax on its excess net passive income under § 1375.
            1. Note that even $1.00 of subchapter C earnings and profits invokes the passive income limitations. Note also that an election may be made under § 1368(e)(3) to treat distributions as dividend distributions, in effect purging the corporation of its subchapter C earnings and profits.
          1. The definitions of passive income and subchapter C earnings and profits are the same as that used above in applying the excess net passive income tax under § 1375.
    1. Nonterminating Events.
      1. Merger - A § 368 (a)(1)(A) merger of an S corporation into a nonelecting corporation does not terminate its qualified status with respect to its final taxable year (Rev. Rul. 64-94, 1964-1 C.B. 317).
      1. Acquisition of Assets of C Corporation - The election of an S corporation that acquires assets of a non-qualifying corporation will not terminate as a result of the acquisition (Rev. Rul. 69-566, 1969-2 C.B. 165).
      1. Consolidation - The consolidation of two S corporations does not terminate either of the corporations' prior elections for their respective final taxable years ending on the date of the consolidation. The successor corporation, assuming it meets the small business corporation tests, is eligible to elect S corporation status for its new taxable year without having to satisfy the five-year waiting period requirement (Rev. Rul. 70-232, 1970-1 C.B. 177).
      1. B Reorganization - An S corporation that is acquired in a § 368(a)(1)(B) reorganization does not lose its S status for the short taxable year which ends on the date prior to the reorganization, provided the acquired S corporation files on a consolidated basis with the acquiring corporation commencing on the day after the acquisition (Rev. Rul. 80-169, 1980-1 C.B. 138; PLR 7914004 (December 13, 1978)).
      1. C Reorganization - In a § 368(a)(1)(C) reorganization, the corporation's S corporation status does not terminate for the tax year ending on the date of the exchange if substantially all of the corporation's assets are exchanged for voting stock (Rev. Rul. 71-226, 1971-1 C.B. 262).
      1. D Reorganization - In a § 368(a)(1)(D) reorganization, the corporation's S status does not terminate for the taxable year ending on the date of the reorganization (Rev. Rul. 64-94, 1964 C.B. 317). In PLR 8638044 (June 23, 1986), the Service ruled that the momentary ownership of another corporation did not terminate the election in the reorganization (See also GCM 39768).
      1. E Reorganization - An S corporation entering into a § 368(a)(1)(F) reorganization does not lose its S corporation status as a result of the reorganization (Rev. Rul. 64-250, 1964-2 C.B. 333).
      1. Affiliated Group.
        1. Under the rules in effect before January 1, 1997, the Service ruled that a momentary ownership of a subsidiary will not cause a termination of an S corporation even though such ownership creates an affiliated group (Rev. Rul. 73-496, 1972-2 C.B. 312; and Rev. Rul. 72-320, 1972-1 C.B. 270). The period of ownership must be short and the parent corporation must intend that ownership be momentary. In Rev. Rul. 73-496, and PLR 7745041 (August 12, 1977), the Service held that 30 days is permissible momentary ownership. However, the Service has not established a safe harbor or maximum period of ownership. In Haley Brothers Construction Co. v. Comm'r, 87 T.C. No. 26 (1986), an S corporation engaged in heavy construction acquired all of the stock of a real estate developer. The real estate corporation was in debt to the S corporation and the S corporation acquired the developer in order to complete the real estate development which gave rise to the debt. The S corporation operated the new corporation as a division and dissolved the real estate corporation approximately twenty-three months after acquisition. The court held that the S corporation status was terminated upon acquisition because of the affiliated group rules.
        1. Current sales now allow an S corporation to be a member of an affiliated group, but the affiliated group may not file a consolidated return.
      1. State Law Suspension - The IRS held in PLR 9411040 (December 21, 1993), that a corporation's election did not terminate where it was administratively dissolved under state law because it failed to file its annual report and pay its annual license fee. The law contained a revival provision which the corporation had used.
    1. Inadvertent Terminations.
      1. If a corporation's S corporation election is terminated due to its ceasing to be a small business corporation or failing the passive income test, the Service may nevertheless allow the corporation to continue to be treated as an S corporation if the following requirements are met under § 1362(f):
        1. The Service determines that the termination was inadvertent;
        1. Steps are taken to correct the cause of the termination within a reasonable time of discovery (includes steps taken by the corporation so that it no longer violates passive investment income limitations (Reg. § 1.1362-4(a)); and
        1. The corporation and every person who was a shareholder agree to adjustments as may be required by the Service (Reg. § 1.1362-4(a)).
      1. The determination of whether a termination was inadvertent will be made by the Commissioner. The corporation has the burden of establishing the relevant facts and circumstances that the Commissioner should use in determining that the termination was inadvertent. The fact that the terminating event was not reasonably within the control of the corporation and was not part of the plan to terminate the election, or the fact that the event took place without knowledge of the corporation, notwithstanding its due diligence in the course of its business to safeguard itself against such event, tends to establish that the termination was inadvertent. For example, if a corporation, in good faith and using due diligence, determined that it had no subchapter C earnings and profits, but it was later determined on audit that its election terminated by reason of violating the passive investment income test for three consecutive taxable years because the corporation had in fact accumulated earnings and profits, it may be appropriate for the Commissioner to find that the terminating event was inadvertent (Reg. § 1.1362-4(b)).
      1. A corporation that believes its election was terminated inadvertently is required to request a determination of inadvertent termination from the Commissioner. The request must be made in the form of a ruling request and must contain the information required by regulations and revenue procedures pertaining thereto. The request shall set forth all relevant facts pertaining to the event including, but not limited to, the fact that the terminating event was not reasonably within the control of the corporation and was not part of a plan to terminate the election, a detailed explanation of the event causing termination, when and how such event was discovered, and the steps taken to return the corporation to small business corporation status.
      1. In order to satisfy the requirements of the inadvertent termination, a corporation, the election of which terminates by reason of a disqualifying event, must, within a reasonable period of time after discovery of such event, takes steps to correct the event so that the corporation is once more a small business corporation. For example, if the terminating event is one that causes the corporation to have more than one class of stock, the corporation must take steps to eliminate the second class of stock. If the election is terminated because the corporation had an ineligible shareholder, the corporation must take steps to terminate such shareholder's interest. If the cause of termination is excessive passive investment income, the corporation must reduce such excess income or eliminate its subchapter C earnings and profits (Reg. § 1.1362-4(a)).
      1. For purposes of correcting the terminating event, a corporation is considered to have discovered the terminating event when it has actual knowledge of such event, or at such time as a reasonable person would have knowledge of such event. Before a waiver can become effective, the steps taken must be completed so that the corporation is once more a small business corporation (Reg. § 1.1362-4(a)).
      2. Before any waiver is granted, the corporation and the shareholders must consent to any adjustment required by the Commissioner for the specified period. The adjustment required must be consistent with the treatment of the corporation as an S corporation during the specified period. The period specified by the Commissioner may be retroactive either for all years or for the period in which the corporation again became eligible for treatment under the S corporation provisions.
        1. All persons who were shareholders of the corporation at any time during the period specified by the Commissioner, must consent to the Commissioner's adjustment.
        1. Shareholder and corporate consents must be in the form of statements setting forth the Commissioner's requirements, the period for which a waiver of the terminating event is given, and must be signed by the shareholder (in the case of shareholder consent) or the person authorized to sign the return (in the case of corporate consent).
        1. A shareholder's consent statement shall set forth the name, address, and the taxpayer identification numbers of the corporation and shareholder, the number of shares of stock owned by the shareholder during the period, and the dates during the period on which such stock was owned.
        1. The corporate consent statement shall set for the name, address, and taxpayer identification numbers of the corporation and each shareholder.
        1. The consent of the shareholders and of the corporation must be attached to the return for the period in which the adjustments are to be made (Reg. § 1.1362-4(e)).
      1. In the case of a transfer of stock to an ineligible shareholder which is treated as inadvertent termination under § 1362(f), the Commissioner may require such an adjustment as will cause the ineligible shareholder to be treated as a shareholder of an S corporation during the period such shareholder actually held stock in the corporation. Moreover, the Commissioner may require such protective adjustments as will prevent any loss of revenue which may otherwise result because of a transfer of stock to an ineligible shareholder (e.g., a transfer to a nonresident alien). The agreement to make the required adjustments may be reflected in a closing agreement entered into pursuant to § 7121 (Reg. § 1.1362-4(d)).
      1. The status of the corporation after the terminating event and before the determination of inadvertence shall be determined by the period of waiver specified by the Commissioner. The waiver may be granted retroactive for all years for which the terminating event was effective, in which case the corporation will be treated as if its election had not terminated. A waiver may be granted retroactive only for the period in which the corporation again became eligible for S corporation treatment, in which case the corporation will be treated as a C corporation during the period for which the corporation was not eligible for S corporation treatment (Reg. § 1.1362-4(f)).
        1. As an example, the Service waived the automatic S corporation termination in Rev. Rul. 86-110, 1986-2 C.B. 150, where the majority shareholder transferred stock to an ineligible trust. The shareholder acted on advice of counsel and would not have made the transfer but for this advice. Within a reasonable period of time after discovery of the termination, the shareholder took steps to correct the problem so that the corporation once again qualified as an S corporation. The Service ruled that the S corporation was treated as continuing since the termination was inadvertent and the shareholders agreed to make all necessary adjustments as may be required by the Service. (See also Rev. Proc. 94-23, 1994-1 C.B. 609, where the IRS has provided a way for corporations whose S corporation status has been terminated because the stock of the corporation was transferred to a trust whose current income beneficiary (or its legal representative) inadvertently failed to file a timely election to be a qualified subchapter S trust. S corporations that satisfy the prescribed criteria are automatically granted inadvertent termination relief. Essentially, automatic relief will be granted if the income beneficiary files a QSST election and various supporting documents within two years of the original due date. This automatic procedure should be used in lieu of the letter ruling procedure that is usually followed to obtain inadvertent termination relief; user fees do not apply to this corrective action).
        1. Of interest to practitioners, Rev. Rul. 86-110 provides certain factors on which the Service focused:
          1. The shareholder transferring the stock to the trust acted on advice of counsel and would not have made the transfers but for this advice;
          1. The corporation had the ineligible shareholders "for a limited amount of time before discovering the incorrection". The ruling does not, however, state how long the limited period was.
          1. The ruling states that the shareholder who had made the transfer to the trust took the necessary steps to correct the problem, but gives no indication of what was done. Presumably, the stock was transferred out of the ineligible trusts.
      1. Illustrating the effect of an inadvertent termination is PLR 9138025 (June 19, 1991). In PLR 9138025, a shareholder of a C corporation pledged his stock as collateral to secure a personal loan. The corporation subsequently made an S election. Later, the shareholder defaulted on his loan and the bank foreclosed. Since the bank was an ineligible shareholder, the corporation's S election terminated as of the date of the foreclosure.
        1. Five months later, the corporation negotiated an arrangement under which it redeemed the stock the bank owned as a result of the foreclosure. The corporation then applied for § 1362(f) inadvertent termination relief. The IRS ruled that the termination was inadvertent and that the corporation would be treated as continuing to be an S corporation during the period that the bank owned the stock, provided that the bank agreed to report its pro-rata share of flow-through income from the corporation. If the bank did not agree to do so, no inadvertent termination relief would be granted.
        1. The ruling offers several lessons. First, it illustrates the risk of pledging S corporation stock as collateral for a loan. It also points out the potential advantage of a shareholder agreement prohibiting the pledging of S corporation stock.
        1. Another lesson is that the IRS is willing to grant inadvertent termination relief in such situations even when the ineligible shareholder has held the stock for a significant period of time. However, relief will be granted only if the ineligible shareholder agrees to report its share of flow-through income or loss. In negotiating a redemption of stock from an ineligible shareholder, an S corporation should attempt to obtain the ineligible shareholder's consent to flow-through treatment of corporate income, gains, deductions and credits. Generally, the ineligible shareholder might want to be reimbursed for any resulting tax liability. This can be accomplished by adjusting the redemption price to be paid for the stock.
    1. S Election after Termination.
      1. Once the S corporation election is terminated, it generally may not be reinstated by the same or successor corporation prior to the fifth year beginning after the year of termination (§ 1362(g); Reg. § 1.1362-5(a)).
        1. Under Reg. § 1.1362-5(a), a successor corporation is a corporation (1) 50% or more of the stock of which is owned, directly or indirectly, by the same persons who, on the date of termination, owned 50% or more of the stock of the small business corporation with respect to which the election was terminated and (2) which acquires a substantial portion of the assets of such small business corporation or a substantial portion of the assets of which were assets of such small business corporation (Reg. § 1.1362-5(b)).
      1. The Service is authorized to grant consent to an earlier re-election (Reg. § 1.1362-5(a)).
        1. Consent may be granted if it can be shown that the termination was not reasonably within the control of the corporation or of shareholders having a substantial interest in the corporation (Rev. Rul. 78-275, 1978-2 C.B. 221; Rev. Rul. 67-382, 1967-2 C.B. 298, Rev. Rul. 78-364, 1978-2 C.B. 225 and Reg. § 1.1362-5(a)).
        1. Where the termination of S corporation status results in substantial tax benefits (such as the use of a net operating loss which would have otherwise been unavailable for use by the shareholders), the Service may be reluctant to permit an early re-election (Rev. Rul. 78-307, 1978-2 C.B. 222).
        1. The Commissioner will consent to an earlier election by a terminated S corporation if more than 50% of the stock in the corporation is currently owned by persons who did not own stock in the corporation at the date of its termination (See Rev. Rul. 78-332, 1978-2 C.B. 223; Rev. Rul. 78-274, 1978-2 C.B. 200; and Reg. § 1.1362-5(a)).
        1. In PLR 8541078 (July 17, 1985), the Service refused to waive the five-year requirement where the corporation had revoked its S corporation election based on "bad advice" from its former tax accountant. The new accountant recommended that S corporation status be retained for the current and all succeeding years. In denying the request for permission to withdraw the revocation, the Service stated: "There is no statutory authority that permits the withdrawal of a revocation of S corporation status once filed. The fact that the act was based upon faulty advice received from counsel does not alter the rule that a revocation may not be withdrawn".
      1. An S corporation, however, that applied for S corporation status may make another election within five years where the prior election was invalid (See PLR 8638041 (June 23, 1986)).
      1. Under Reg. § 1.1362-5(c), the five year waiting period does not apply to corporations if the termination occurred because the corporation:
        1. Revoked its election effective on the first day of the first taxable year for which its election to be an S corporation was effective, or
        1. Failed to meet the definition of the small business corporation on the first day of the first taxable year for which its election to be an S corporation was effective.
          1. Thus, for terminations described above, a corporation is not required to wait five years for re-election and is not required to secure the consent of the Commissioner for such re-election.
      1. However, the IRS has issued a number of private letter rulings holding that a corporation that files an S election and then revokes it as of the date it would have become effective, can later make another S election without waiting the five year period prescribed in § 1362(g) (See, for example, PLR 9040033, PLR 9036035, PLR 9036021, and PLR 9034058). Many practitioners have wondered why a corporation would bother going to the effort and expense of obtaining a Private Letter Ruling that merely states what is clearly provided in Reg. § 1.1362-(5)(c)(1). Reg. § 1.1362-(5)(e)(1) states that the five year waiting period cannot apply to a corporation if the termination occurred before the corporation revoked its election effective on the first day of the first taxable year for which its election to be an S corporation was effective. Thus, a corporation is not required to wait five years for re-election and is not required to secure the consent of the commissioner for such re-election.
        1. As it turns out, the reason all the rulings are being issued is that the IRS's current practice is to refuse to accept an S election on Form 2553 by a corporation that previously revoked an S election before it took effect unless the corporation first obtains a private letter ruling consenting to the re-election.
          Example 1: On August 10, 2001, a calendar year C corporation made an S election effective as of January 1, 2002. However, before March 15, 2002, the corporation revoked its election. The revocation was retroactive to January 1, 2002. The corporation now wants to make a new election, effective as of January 1, 2003.
        1. When a corporation in the situation described above submits a new Form 2553 to an IRS Service Center with a letter explaining the facts, the Service Center will forward the application to the IRS National Office. In turn, the national office will advise the corporation that it must apply for a private letter ruling. Even though Reg. § 1.1362-(5)(c)(1) states to the contrary, it is the IRS' position that any corporation intending to make an S election under the facts described in the example above is required to apply for a private letter ruling consenting to the re-election within the five years after revoking a prior election.
      1. In PLR 8643032 (July 29, 1986), the Service ruled that momentary affiliation did not invoke the five-year waiting period for a new S corporation election when an S corporation merged downstream into a C corporation under § 368(a)(1)(A). The Service held that the surviving C corporation can elect S status prior to the five-year period provided in § 1362(g).
      1. For purposes of the five-year rule, the SBA provides that any termination of subchapter S status in effect immediately before the date of enactment (i.e., August 20, 1996) is not to be taken into account. Thus, any small business corporation that had terminated its S corporation election within the five-year period before the date of enactment (i.e., August 20, 1996) may re-elect S corporation status without the consent of the Secretary of the Treasury.
        1. This provision is effective for terminations occurring in a taxable year beginning before January 1, 1997.
        1. Expeditious Consent to Change Accounting Period and Elect S Corporation Status.
          1. In Notice 97-20 (February 27, 1997), the IRS stated that it will waive certain limitations on a corporation's ability to expeditiously (i.e., without the Commissioner's prior written approval) change its annual accounting period under Reg. § 1.442-1(c) or Rev. Proc. 92-13, 1992-1 C.B. 665, in order to elect to be an S corporation under § 1362 effective for the taxable year beginning January 1, 1997. Notice 97-20 provides specific procedures a corporation must follow to request an expeditious change of accounting period, and subsequently elect to be an S corporation.
          1. Pursuant to § 1378, an S corporation generally must have a calendar year. However, a corporation may not expeditiously change its annual accounting period to a calendar year if it attempts to elect to be an S corporation effective for the taxable year immediately following the short period required to effect the change (see Reg. § 1.442-1(c)(2)(v); Rev. Proc. 92-13). In addition, a corporation is precluded under Reg. § 1.442-1(c)(2)(i) from expeditiously changing its annual accounting period if the corporation has changed it within the last ten calendar years, and under Rev. Proc. 92-13, if the corporation has changed it within the last six calendar years.
          1. The SBA significantly amended the S corporation provisions, expanding eligibility to elect to be an S corporation. These amendments generally effective for taxable years beginning after December 31, 1996, were intended to allow more corporations to elect to be S corporations as of January 1, 1997.
          2. Consistent with this intent, Notice 97-20 provides that the IRS will waive the limitations of Reg. § 1.442-1(c)(2)(i) and Rev. Proc. 92-13 on a corporation's ability to expeditiously change its annual accounting period to a calendar year effective for the short period ending December 31, 1996, provided that the corporation:
            1. Is otherwise eligible to change its annual accounting period under either Reg. § 1.442-1(c) or Rev. Proc. 92-13;
            1. Is a small business corporation (as described in § 1361(b)) and timely elects to be an S corporation effective for the taxable year beginning on January 1, 1997; and
            1. Follows the following procedures:
              1. Properly completes a Form 2553;
              1. Properly completes a Form 1128 and attaches it to the Form 2553;
              1. Writes "FILED UNDER NOTICE 97-20" at the top of both the Form 2553 and the Form 1128; and
              1. Timely files the Form 2553 with the appropriate Service Center in accordance with the instructions for Form 2553. A corporation that qualifies to automatically change its accounting period under Reg. § 1.442-1(c) as a result of Notice 97-20 should not file the statement required by Reg. § 1.442-1(c)(1).
    1. Allocation of Income in Year of Termination.
      1. A termination by revocation or by ceasing to be a small business corporation may take effect during the corporation's tax year.
        1. If the termination takes effect during the corporation's tax year, the corporation's tax year is divided into two short taxable years, an "S short year" and a "C short year."
        1. The S short year includes the portion of the S termination year (i.e., the year during which the election is terminated) ending on the day before the termination is effective (§ 1362(e)(1)(A)).
        1. The C short year consists of the portion of the S termination year beginning on the day the termination is effective (§ 1362(e)(1)(B) and Reg. § 1.1362-3).
      1. The S short year is subject to the rules governing S corporations. Similarly, the C short year is subject to the rules applicable to C corporations. Consequently, income and deductions for the S termination year must be allocated between the S short year and the C short year. The statute allows this allocation to be made under either of two methods: general pro rata allocation rules and closing of books under normal accounting rules.
      1. General Pro Rata Allocation Rule - Under this method, an equal portion of each item of income, loss, deduction, or credit, the separate treatment of which could affect the tax liability of any shareholder, and of the amount of the nonseparately-computed income or loss, is allocated between the S short year and the C short year (§ 1362(e)(2) and Reg. § 1.1362-3(a)).
        1. This rule precludes the need to close the corporation's books as of the close of the S short year.
        1. The items of income, gain, loss, deduction, and credit for an S termination year are allocated between the S short year and the C short year in the following manner:
          1. Determine, for the entire S termination year, the amount of each of the separately stated items of income, loss, deduction, or credit, and the amount of non-separately computed income or loss,
          1. Assign an equal ratable portion of each amount to each day of the S termination year. For example, if a corporation has an S termination year in 2000 that consists of an S short year from January 1 through June 30 and a C short year from July 1 through December 31, it will make a pro rata allocation of 181 divided by 365 of its separately and non-separately computed amounts to the S short year and will allocate 184 divided by 365 of such amounts to the C short year.
        1. The pro rata allocation rules will not apply:
          1. If an election is made by the corporation to have items assigned into each short year under the corporation's normal tax accounting rules.
          1. To any item resulting from an election made by an acquiring corporation to treat the purchase of the corporation's stock as an asset purchase under § 338, or
          1. There is a sale or exchange of 50% or more of the stock of the corporation during an S termination year (§ 1362(e)(6) and Reg. § 1.1362-3(a)).
        1. Where the pro rata allocation rules do not apply, the corporation will allocate items of income, gain, loss, deduction, and credit under normal tax accounting rules (Reg. § 1.1362-3(a)).
      1. Election to Close Books - The corporation may instead elect to report taxable income or loss for the C short year and the S short year on the basis of income or loss shown under the corporation's method of accounting (§ 1362(e)(3); Reg. § 1.1362-3(b)).
        1. A corporation may elect under § 1362(e)(3) to allocate its S termination year income on the basis of its normal tax accounting method rather than under the pro rata allocation method. An election to close the books can be made only with the consent of all persons who were shareholders in the corporation at any time during the S short year and all persons who are or were shareholders in the corporation at any time during the first day of the C short year.
          1. To make such election, corporation must file a statement that it elected under § 1362(e)(3) to have the pro rata allocation rules not apply.
          1. Such statement must set forth the cause of the termination and the date thereof and must be signed by any person authorized to sign the return.
          1. The statement must be filed with the return for the short taxable year. In addition, there must be attached to the statement of election a statement of consent, signed by each shareholder who is or was a shareholder in the corporation at any time during the S short year and each person who is or was a shareholder of the corporation at any time during the first day of the C short year.
          1. The separate statement must set forth the name, address, and taxpayer identification number of the corporation, and the name, address, and taxpayer identification number of each person required to consent (Reg. § 1.1362-6(a)(5) and Reg. § 1.1362-6(b)).
        1. Therefore, buy-sell agreements, corporate shareholder agreements, and other similar agreements should specify which allocation method will be used if the S corporation election is inadvertently terminated. Obviously, before an agreement is made requiring consent to separate the two years, the tax effects of the two allocations must be analyzed.
        2. Under Reg. § 1.1362-3(b)(3), the pro rata allocation method will not apply to an S termination year if at any time during such year, as a result of sales or exchanges of stock in the corporation during the year, a § 338 election is made or there is a change in ownership of 50% or more of the issued and outstanding shares of stock of the corporation. (If stock has already been sold or exchanged during the S termination year, subsequent sales or exchanges are not taken into account.) In such a case, the closing of the books is required (Reg. § 1.1362-3(b)(2) and (b)(3)).
        1. Reg. § 1.1362-3(c) provides that if (1) an S corporation's election terminates, (2) the corporation is required to use the closing of the books method of allocating income or loss between the S corporation and the C corporation in short taxable years, (3) the corporation is a partner during any portion of the S short taxable year, and (4) the taxable year of the partnership ends within the C short taxable year, then for purposes of § 706(c), the termination of the S election will be treated as a sale or exchange of the corporation's entire interest in the partnership. As a result, the partnership year will close with respect to the corporation as of the termination date. Thus, the corporation's pro rata share of partnership income or loss through the termination date must be allocated to the S corporation short taxable year. In addition, the Service probably intends that the above rule apply for purposes of § 708(b)(1)(B) (i.e., termination of a partnership by reason of a sale or exchange of 50% or more interest in partnership capital and profits within a twelve month period). Accordingly, if an S corporation owns 50% or more of the total interest in partnership capital and profits and its S election is terminated, the Service will probably view the regulation as terminating the partnership.
          Example 2: A, an individual, owns all 100 outstanding shares of stock of S, a calendar year S corporation. On January 31, 2003, A sells 60 shares of S stock to B, an individual. On June 1, 2003, A sells 5 shares of S stock to PRS, a partnership. S ceases to be a small business corporation on June 1, 2003, and its S election terminates on that date. Because there was a more than 50% change in ownership of the issued and outstanding shares of S stock, S must assign the items of income, loss, deduction, or credit for the S termination year to the two short taxable years on the basis of S' normal method of accounting.
          Example 3: A, an individual, owns all 100 outstanding shares of the stock of S, a calendar year S corporation. On June 1, 2003, A sells 5 shares of S stock to PRS, a partnership. S ceases to be a small business corporation on that date and its S election terminates on that date. On July 1, 2003, A sells 60 shares of S stock to B, an individual. Since there was a more than 50% change in ownership of the issued and outstanding shares of S stock during the S termination year, S must assign the items of income, loss, deduction, or credit for the S termination year to the two short taxable years on the basis of S' normal method of accounting.
          Example 4: C and D are shareholders in S Co., a calendar year S corporation. Each owns 50% of the issued and outstanding shares of the corporation on December 31, 2002. On March 1, 2003, C makes a gift of his entire shareholder interest to T, a trust not permitted as a shareholder under § 1361(c)(2). S Co. ceases to be a small business corporation on March 1, 2003, and its S election terminates effective on that date. As a result of the gift, T owns 50% of S Co.'s issued and outstanding stock. However, because T acquired the stock by gift from C rather than by sale or exchange, there has not been a more than 50% change in ownership by sale or exchange of S Co. that would cause the rules of Reg. § 1.1362-3(b)(3) to apply. Therefore, S Co. may use either the pro rata allocation method or it may elect to allocate its S termination year income on the basis of its normal tax accounting method. It is not required to do so.
      1. If the termination of the S corporation takes effect during the taxable year, the taxable income and tax for the C short year must be annualized (§ 1362(e)(5)(A) and Reg. § 1.1362-4(d)). The taxable income and tax are annualized as follows:
        1. Annualized C short year income =

Taxable income forC short year

x

Number of Days in
S Termination Year

Number of Days in
C Short Year

        1. Tax for C short year =

Tax computed on annualized C short year income

x

Number of Days in
C Short Year
Number of Days in
S Termination Year

      1. The alternative minimum tax under § 55, if applicable, must also be computed by multiplying the § 55 tax by the number of days in the C short year and dividing by 365 (Reg. § 443(d) and Reg. § 1.1362-4(d)).
      1. The S short year and the C short year are treated as only one taxable year for purposes of determining the number of years to which subchapter C net operating losses and other carryovers may be carried (§ 1362(e)(6)(A) and Reg. § 1.1362-4(e)(1)).
      1. The return for the S short year is due on the same date as the return for the C short year (including extensions) (§ 1362(e)(6)(B) and Reg. § 1.1362-4(e)(2)).
        Example 5: A corporation determines that it has taxable income of $4,000 for the C short year December 12, 2003 through December 31, 2003. The taxable income on an annual basis is $73,000 ($4,000 x 365 divided by 20), tax on the annualized taxable is $13,250 ($7,500 plus $5,750), and the tax liability for the C short year is $726 ($13,250 x 20 divided by 365).
    1. Post-Termination Distributions.
      1. Distributions a corporation made after termination of its S corporation election would be treated just like distributions from any other C corporation if the relief provisions of § 1371(e) were not available. Section 1371(e) permits tax-free distributions for a limited time after the termination of S corporation status to the extent of the corporation's accumulated adjustments account (AAA) and to the extent of a shareholder's stock basis. (See FSA 200207015 which allowed the individual to increase his basis by the stock that he purchased during the post-termination transition period.)
        1. This provision is literally restricted to corporations with an AAA account. Thus, this rule would seem to apply only to S corporations that were required to maintain an AAA because they had AEP. This appears to be an unintended result and those S corporations without AEP should maintain a record of their AAA. Note that the instructions to Form 1120S require the AAA to be maintained even if the corporation does not have AEP.
      1. To qualify for tax-free treatment under § 1371(e) after the termination of S corporation status, the following requirements must be met:
        1. The distribution must be in money;
        1. The distributions must be made by the corporation with respect to its stock; and
          1. The language is broad enough to cover a redemption under § 302(a) as well as distributions subject to § 301.
        1. The distribution must occur during a post-termination transition period.
          1. Under § 1377(b), that phrase is defined to mean one or both of two periods.
            1. The first period is the period beginning on the day after the last day of the corporation's last taxable year as an S corporation and ending on the latter of: (i) one year after such last day; or (ii) the due date of the return for the last S corporation taxable year (including extensions) (§1377(b)(1)(A)). In the case of a midyear termination, the post-termination transition period begins on the day after the S short year, not the day after the S termination year.
            1. The second period is a 120-day window that opens on the date of a determination that S corporation status has ended, or the 120-day period beginning on the date of any determination pursuant to an audit of the taxpayer that follows the termination of the S corporation's election and that adjusts a subchapter S item of income, loss or deduction of the S corporation during the S period (§ 1377(b)(1)(B)). Under § 1377(b)(2), a determination includes a final court decision, a closing agreement, or an agreement between the Service and the corporation that S corporation status ended, or a final disposition of the Secretary of the Treasury of the claim for refund and, under regulations, certain agreements between the Secretary and any person, relating to the tax liability of the person.
              1. An agreement by one or more shareholders with the IRS apparently will not start the period.
          1. Several years may elapse between the end of the S short year and the 120-day period. That delay may give the corporation time to raise the money for a tax-free distribution (to the extent of the shareholder's basis in his stock, but in no event in excess of the corporation's AAA). However, § 1371(e)(1) will not apply to distributions made between the two periods outlined above.
            Example 6: S Co.'s S corporation status ends by revocation for its taxable year beginning January 1, 2003. S has a $200 AAA on that date, has $100 of accumulated earnings and profits, and A, the sole shareholder, has a basis of 150 in his stock.
            S Co. has until December 31, 2003 to make a tax-free cash distribution of $150 to A. If S Co. instead distributes $200 to A during this period, $150 will be tax free to A and the remaining $50 will be treated as a dividend under § 301(c). (Not certain the above is true. There may be a drafting oversight in § 1371(e), such that, in the above example, $150 is tax free and $50 is a capital gain under § 1368(b)(2).)
      1. S Corporation Shareholder May Apply Suspended Losses to C Corporation Stock During PTTP.
        1. In FSA 200223052, the IRS ruled that a shareholder of a target S corporation, who is also a shareholder of an acquiring C corporation, may apply suspended losses against the shareholder's historic basis in the C corporation stock, but the shareholder must reduce his historic basis in the C corporation stock for the losses taken.
        1. In FSA 200223052, an S corporation merged into a C corporation in a merger that qualified as an "A" reorganization under § 368(a)(1)(A). Before the merger, a shareholder owned stock in the S corporation with a zero basis. The same shareholder also owned stock in the C corporation with a basis of $100. The shareholder had $150 of suspended losses at the time of the merger. After the merger, the shareholder had two blocks of stock in the C corporation - the stock received in the merger with a zero basis, and his historic C corporation stock, with a basis of $100. The shareholder did not make contributions to, or receive distributions from, the C corporation with respect to the C corporation's stock during the post-termination transition period (PTTP). A question arose as to whether the shareholder could apply his suspended S corporation losses against his historic basis in the C corporation stock.
        1. The National Office advised that the shareholder of a target S corporation, who is also a shareholder of an acquiring C corporation, may apply his suspended S corporation losses against his historic basis in the C corporation stock. However, the shareholder must reduce his historic basis in the C corporation stock for the losses taken.
        1. According to the National Office, both the statute and the legislative history contemplate a situation in which a shareholder may acquire additional basis during the PTTP. The purpose of § 1366(d)(1), the National Office explained, is to prevent shareholders from using losses that are not related to any corresponding economic outlay. In this case, the National Office noted, the shareholder made economic outlays in the form of his investment in the acquiring C corporation. The National Office concluded that the shareholder can deduct $100 of the $150 suspended losses as a result of the shareholder's historic basis in the C corporation stock, and the remaining $50 of suspended losses would be permanently disallowed. (See also FSA 200207015 where a shareholder was able to use the suspended loss when he purchased additional shares during the PTTP.)
    1. Effects of Termination and Revocation - The general effects of the termination of an S corporation election are:
      1. The corporation's income ceases to flow through to the shareholders under § 1366(a).
      1. Losses cease to flow through to shareholders under § 1366(a). However, under § 1366(d)(3), a shareholder with losses in excess of basis may use the losses after termination when the shareholder acquires basis during the post-termination transition period (See § 1377(b)).
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