Key Takeaways

  • S corporations can lose their status voluntarily through shareholder revocation or involuntarily by violating eligibility requirements.
  • Common causes of termination include exceeding the 100-shareholder limit, having ineligible shareholders, creating a second class of stock, or surpassing passive income limits for three consecutive years.
  • Voluntary terminations require written shareholder consent (usually from over 50% of voting shares) and timely filing with the IRS.
  • Inadvertent terminations can sometimes be reversed if the IRS determines the violation was unintentional and corrective measures are taken.
  • S corp termination consequences may include conversion to C corporation tax status, changes in shareholder income reporting, and potential built-in gains tax.
  • Preventive strategies—such as shareholder agreements and careful income monitoring—can reduce the risk of unintended termination.

An S corporation can be terminated voluntarily or involuntarily. Whatever the reason, errors that could cause a corporation to be terminated involuntarily should be taken care of as soon as they are discovered.

Overview of an S Corporation

An S corporation is a corporation that is taxed as a pass-through entity. In order to qualify as an S corporation, the following criteria under Sec. 136(b) must be met.

  • The company must be a domestic corporation with all investors and shareholders U. S. citizens or resident aliens.
  • An S corporation cannot have foreign investors.
  • An S corporation must have allowable shareholders versus ineligible shareholders.
    • Certain types of trusts, individuals, and estates qualify as shareholders while other corporations, partnerships, or non-resident aliens are not eligible to be shareholders.
  • The S corporation is limited to no more than 100 shareholders.
  • S corporations can only have one class of stock that is distributed proportionately among multiple shareholders. This eliminates any preferential treatment of one shareholder over another.
  • The corporation cannot be an insurance company, a domestic international sales corporation, or a bank.
  • S status has not been previously terminated due to the business ceasing to qualify as a small business entity.
  • The corporation's passive income exceeds the passive income limitation.

In order to maintain its status, an S corporation must comply with these rules.

Voluntary vs. Involuntary Termination of S Status

An S corporation’s election can be terminated in two primary ways: voluntarily or involuntarily.

Voluntary Termination:

  • Requires written consent from shareholders holding more than 50% of the corporation’s voting shares.
  • The revocation statement must be signed, dated, and filed with the IRS, generally specifying the effective date. If no date is given, termination begins on the first day of the tax year in which it’s filed.
  • Early planning is crucial to avoid unintended tax consequences, such as being taxed as a C corporation mid-year.

Involuntary Termination:

  • Occurs automatically if the corporation no longer meets eligibility criteria—such as having more than 100 shareholders, issuing a second class of stock, or having ineligible shareholders (e.g., partnerships or non-resident aliens).
  • Can also happen if the corporation’s passive income exceeds 25% of gross receipts for three consecutive years when it has accumulated earnings and profits from C corporation years.

Both types of terminations can have significant tax and operational consequences, making it important to monitor compliance year-round.

Relief for Inadvertent Termination of an S Corporation

It is possible for a corporation's S status to be reinstated or restored if the corporation can demonstrate the violation was inadvertent. Only the IRS can determine whether the termination was advertent or if the errors was the corporation's fault. If the termination is deemed inadvertent and the proper steps are taken, the IRS has the option to continue treating the entity as an S corporation.

If a corporation is eligible to be reinstated, the IRS may waive the termination and restore its S status when the following stipulations are in place.

  1. There was a valid S election in existence that has been terminated.
  2. The loss of the subchapter S election was instigated by an inadvertent act.
  3. The Internal Revenue Service makes the determination if the termination was inadvertent.
  4. Steps have been taken to correct the condition that resulted in the corporation being rendered ineligible for S status.
  5. The persons who were shareholders during the period the S corporation was terminated agree to any adjustments requested by the IRS.

Two steps an S corporation can take to protect itself from involuntary termination include:

1. Shareholders should enter into an agreement that allows the S corporation to buy back stock from shareholders who may be leaving the corporation. With an agreement, the possibility of a shareholder leaving the corporation and selling their shares to an ineligible person, thus jeopardizing the corporation's S status, is minimized.

2. Monitoring the corporation's ratio of passive income to total income can help prevent the corporation from earning more than 25 percent of its revenues from passive income over three successive years.

Tax and Legal Consequences of S Corp Termination

The s corp termination consequences can be extensive and may impact both the corporation and its shareholders:

  1. Reversion to C Corporation Tax Status – The business will be taxed at the corporate level, and shareholders will face double taxation on dividends.
  2. Built-In Gains Tax – If the corporation sells appreciated assets within five years of termination, it may owe a built-in gains tax, which can significantly reduce net proceeds from asset sales.
  3. Accounting Method Changes – The corporation may need to adjust its accounting methods or reporting periods to comply with C corporation rules.
  4. Loss of Pass-Through Benefits – Shareholders will no longer be able to report corporate income and losses on their personal tax returns, which can increase overall tax liability.
  5. Impact on Capital Accounts – Termination may trigger the need for capital account adjustments and reallocation of income, losses, and distributions.

Careful planning before termination—voluntary or otherwise—can help mitigate these consequences.

Disproportionate Distributions

A common mistake made by an S corporation is to make a disproportionate distribution. Doing so can make it seem like the corporation is offering a second class of stock. An S corporation is only allowed to offer one class of stock, so this violation would result in the termination of S corporation status.

An example of a disproportionate distribution would be a corporation electing S corporation status on its initial formation day. Within the year, the corporation made distributions to its shareholders that were disproportionate, meaning it did not make distributions to all the shareholders. The disproportionate distributions were discovered and corrected.

Preventing Termination Risks

S corporations can take proactive steps to avoid the costly and disruptive effects of termination:

  • Regular Compliance Audits – Periodically review shareholder eligibility, stock ownership records, and distribution practices.
  • Draft Shareholder Agreements – Include clauses requiring the sale of shares to eligible parties if a shareholder intends to transfer ownership.
  • Monitor Passive Income – Keep passive income levels below 25% of gross receipts for three consecutive years when the corporation has C corp accumulated earnings.
  • Educate Shareholders – Ensure all shareholders understand the rules regarding stock classes, distributions, and eligible ownership.
  • Coordinate Major Transactions – Seek tax counsel before making significant changes in ownership structure or income sources.

By implementing these measures, S corporations can reduce the likelihood of termination and protect their tax advantages.

Frequently Asked Questions

  1. What triggers involuntary S corp termination?
    Violations like having ineligible shareholders, issuing a second class of stock, exceeding 100 shareholders, or passive income limits can trigger termination.
  2. How can shareholders voluntarily terminate S corp status?
    Shareholders holding more than 50% of voting shares must file a signed revocation with the IRS, specifying an effective date if desired.
  3. Can an S corp termination be reversed?
    Yes, if the IRS determines the violation was inadvertent and corrective actions are taken, status may be reinstated.
  4. What happens tax-wise after termination?
    The corporation reverts to C corporation taxation, potentially facing double taxation, built-in gains tax, and accounting method changes.
  5. How can an S corp avoid termination?
    Maintain shareholder eligibility, monitor income levels, avoid disproportionate distributions, and use shareholder agreements to control ownership changes.

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