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.

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.

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.

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