S Corp Termination Consequences and Final Tax Return

Key Takeaways

• Terminating S corporation status can trigger significant tax consequences, including recognition of built-in gains, capital gains, and shareholder-level tax liabilities.
• Inadvertent terminations — often caused by eligibility violations or shareholder mistakes — can lead to unexpected C corporation taxation and penalties if not promptly addressed.
• Asset distributions after revocation must be valued at fair market value, potentially creating taxable gains even without a cash transaction.
• The IRS imposes a five-year waiting period before a company that revoked or lost its S status can re-elect it, though certain exceptions may apply.
• Properly preparing and filing the final S corporation tax return, including marking it as “Final” and accounting for all income, deductions, and distributions, is critical to compliance.

An S corp termination tax return must be filed when an S corporation is terminated and the owners need to report its financial and tax requirements.

Life Cycle of an S Corporation

The life cycle of an S corporation involves several key steps:

• Formation of an LLC.
• LLC owners elect for taxation as an S corporation by filing Form 2553 with the IRS.
• S corporation opens payroll accounts.
• S corporation status is revoked, and the business sends a letter to the IRS.
• S corporation reverts to taxation as a C corporation.
• Business owners file Form 8832, Entity Classification Election, with the IRS.
• Owners deal with any tax consequences and distributions.
• C corporation closes payroll accounts.
• Owners file the final S corporation tax return, Form 1120S, with the IRS.

Common Triggers for S Corp Termination

Understanding what can cause an S corporation to lose its status is essential to managing risk and planning for potential tax impacts. Termination of S corporation status can occur intentionally — for example, when shareholders revoke the election — or inadvertently, when certain IRS eligibility requirements are violated. Key triggers include:

• Ownership Changes: An S corporation may be terminated if it exceeds the 100-shareholder limit or if shares are transferred to an ineligible shareholder, such as a corporation, partnership, or non-resident alien.
• Multiple Classes of Stock: Issuing a second class of stock, even inadvertently through shareholder agreements that alter distribution or liquidation rights, can terminate S status.
• Passive Income Violations: If an S corporation with accumulated earnings and profits earns more than 25% of its gross receipts from passive investment income for three consecutive years, the IRS may terminate its S election.
• Document Oversights: Provisions in existing shareholder or operating agreements that conflict with S corporation requirements (e.g., preferred returns or disproportionate distributions) can lead to termination if not corrected.

Preventive legal and tax reviews are crucial to identify and fix issues before they jeopardize S status.

Distributed Assets After Revocation

Revoking the status as an S corporation triggers a taxable event. This event could potentially be very large. After the status has been revoked, all business assets are distributed to the shareholders of the S corporation at the fair market value. Before the business can be effectively and legally dissolved, all assets must be fully reviewed. An assessment of fair market values is another step in the dissolution process.

When a business receives cash from a transaction on an appreciated asset, paying the capital gains on that transaction is easy. Paying capital gains becomes much more complicated when the business experiences a cashless revocation of its assets.

Tax Consequences of S Corp Termination

When S corporation status ends, the tax implications can be substantial for both the corporation and its shareholders. The following s corp termination consequences are among the most common:

• Built-In Gains Tax: If appreciated assets are sold within five years of termination, the corporation may owe a built-in gains (BIG) tax on the difference between fair market value and basis.
• Capital Gains and Ordinary Income: Distributions of appreciated assets trigger capital gains recognition at the corporate level, and subsequent distributions to shareholders may be taxed again as dividends or capital gains.
• Shareholder Basis Adjustments: Shareholders must adjust their stock basis for income, losses, and distributions received before termination. Improper adjustments can lead to double taxation or missed deductions.
• State-Level Tax Considerations: Some states impose their own corporate-level taxes after S status termination, even if the entity remains a pass-through for federal purposes.
• Post-Termination Transition Period (PTTP): The IRS allows a one-year PTTP for corporations to make certain distributions and elections as if S status were still in effect. Proper use of this period can help reduce tax liabilities.

Understanding these tax effects before revocation helps shareholders and corporate officers plan asset sales, distributions, and restructuring to minimize liability.

The Five-Year Rule

If an S corporation loses its status, there is a five-year waiting period before it can file to become an S corporation again. An intentional violation of a law or rule that applies to S corporations is not a good idea. One example of an intentional violation is the transfer of stock to a shareholder who is ineligible to receive it.

If the violation of a law or rule was not intentional, the IRS will review on a case-by-case basis. In some cases, the IRS has allowed S corporations to maintain their statuses if a termination event was outside of the owners' control. Private letter rulings or situations that are more difficult to demonstrate can cost a business owner thousands of dollars.

In certain cases, the IRS has also allowed S corporations to maintain their status when the business underwent an ownership change by more than 50 percent. For example, a company elects for taxation as an S corporation but revokes that election within five years. If that company then has an ownership change of more than 50 percent in the five years, it can request a review by the IRS to retain its election as an S corporation. The IRS may grant that request, depending on the circumstances.

Seeking Relief for Inadvertent Termination

In cases where S corporation status is lost unintentionally, the IRS may grant relief if the corporation promptly corrects the error and demonstrates reasonable cause. To qualify:

1. Identify the Cause: Determine whether the termination was due to an ineligible shareholder, issuance of a second class of stock, or another technical issue.
2. Correct the Problem: Amend governing documents, repurchase or reclassify shares, or remove ineligible shareholders to restore eligibility.
3. Request a Private Letter Ruling (PLR): Corporations may submit a PLR request to the IRS explaining the circumstances and asking for relief under Section 1362(f).
4. Demonstrate Reasonable Cause: Provide documentation that the violation was inadvertent, promptly addressed, and not part of an intentional tax avoidance strategy.

Obtaining relief can allow the corporation to retain its S status retroactively, preventing unintended C corporation taxation and associated penalties.

How to Prepare a Final Tax Return for an S Corporation

In the process of terminating an S corporation, one of the required steps is filing a request to dissolve the business. This request must be filed in the state in which the business incorporated. After verifying that the corporation doesn't have any outstanding state taxes, the state will send a certificate of dissolution. This certificate serves as approval from the state to dissolve the business. You can then file the final tax return for the corporation with the IRS.

The deadline for filing your final tax return is the 15th day of the third month after the date of dissolution of the S corporation. If you need an extension, file Form 7004 with the IRS to receive an additional six months to file. You can find the final tax return documentation on the IRS website. Download Form 1120 to review all instructions and schedules.

Be sure to check the box next to “Final” on the form, which will indicate that this form is the final tax return for the corporation before it is dissolved. The next step in filling out the form is listing the income or losses for the business. These items should be listed on lines one through five, with a total on line six. Deductions should be reported on lines seven through 19, with a total on line 20. Deduct the amount on line 20 from the amount on line six to produce the net loss or income for the year.

Post-Termination Compliance and Recordkeeping

After filing the final tax return, compliance obligations don’t end. Businesses should:

• Maintain Corporate Records: Retain copies of all dissolution filings, tax returns, shareholder consents, and distribution documentation for at least seven years.
• File State Final Returns: Some states require separate dissolution filings or final state income tax returns.
• Handle Residual Liabilities: Settle any remaining payroll, sales, or excise taxes before closing accounts.
• Address Shareholder Reporting: Shareholders must report final K-1 allocations of income, deductions, and credits, even if the S election was terminated mid-year.
• Consult Tax Professionals: Complex terminations, especially those involving built-in gains or asset sales, often require professional guidance to ensure compliance and minimize exposure.

Thorough post-termination recordkeeping and compliance efforts protect against IRS audits and potential shareholder disputes.

Frequently Asked Questions

1. What are the most common s corp termination consequences?
   They include built-in gains tax on appreciated assets, shareholder-level capital gains, possible double taxation, and state-level corporate tax exposure.
2. Can an S corporation regain its status after termination?
   Yes. Most must wait five years to re-elect S status, but relief for inadvertent terminations may allow earlier reinstatement.
3. What happens to shareholder basis when an S corp terminates?
   Shareholders must adjust their basis to reflect income, losses, and distributions prior to termination. Improper adjustments can lead to double taxation.
4. Is there a deadline for distributing assets after termination?
   The IRS provides a one-year post-termination transition period (PTTP) for certain distributions and elections, which can help reduce tax liabilities.
5. What documents should be kept after dissolution?
   Maintain tax returns, dissolution filings, shareholder consents, asset appraisals, and distribution records for at least seven years for audit protection.

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