Key Takeaways

  • An S corporation can lose its status involuntarily by violating eligibility rules, such as exceeding the shareholder limit or having ineligible shareholders.
  • The IRS may offer relief for inadvertent terminations if certain conditions are met and corrective action is taken promptly.
  • Corporate documents, such as buy-sell agreements, can unintentionally trigger terminations if they contain provisions inconsistent with S corporation requirements.
  • If S status is lost, the business becomes a C corporation and may face double taxation and other financial consequences.
  • Preventive measures include regular compliance reviews and shareholder agreements to preserve eligibility.

Termination of S corporation status can be voluntary or involuntary. While this may be so, once the election is made to become an S corporation, requirements must be met to avoid the termination of S status inadvertently. S status can be rescinded by the Internal Revenue Service (IRS) or the shareholders of the corporation can choose to give it up. 

Overview of S Corporation Status

The IRS sanctions the tax designation as an S corporation. By doing so, the corporation retains liability protection for its shareholders, but it will be taxed the same as a partnership. This means S corporations are not directly taxed. Instead, shareholders include their share of the corporation's income and losses on their personal income tax return and pay taxes accordingly. 

Several things are in place to choose S status. These are: 

  • There must be less than 100 shareholders
  • No nonresident aliens
  • The stock is limited to one class
  • Certain industries are off-limits

Involuntary Termination of an S Corporation

S corporations are a common choice as an entity structure. Staying current on the qualifications necessary to remain an S corporation is important to avoid inadvertently terminating the corporations' S status. 

There are ways an S corporation can be involuntarily terminated. One way is if any of the qualifications required to become an S corporation are violated. These would include:

  • The corporation gains more than 100 shareholders
  • Gains a nonresident alien or business shareholder
  • Becomes involved with an industry that is not allowed

Another way the S corporation can lose its status is if its gross income is derived from more than 25 percent of gross to passive investment income over the past three tax years. Passive investment income is generated when an S corporation earns income by an activity it is not directly involved with or participated in. Dividends are an example of passive investment income.

Under certain conditions and if the proper steps are taken, the IRS may grant a corporation relief and continue to treat the entity as an S corporation.

Inadvertent Terminations and IRS Relief

Not all terminations are intentional. If an S corporation inadvertently violates eligibility rules, the IRS may allow the company to retain its S status by granting relief under IRC §1362(f).

To qualify, the corporation must demonstrate:

  • The termination was not intentional;
  • Prompt corrective action was taken;
  • All shareholders agree to the relief;
  • The corporation acted in good faith.

A formal request must be submitted to the IRS, often including a Private Letter Ruling (PLR). The request should detail:

  • The nature of the violation;
  • Corrective steps taken;
  • Statements from affected shareholders;
  • Supporting documentation.

Receiving IRS relief can preserve S corporation status retroactively, avoiding adverse tax consequences.

Common Triggers for Involuntary Termination

There are several common ways a corporation can face involuntary termination of its S corporation status:

  • Exceeding the Shareholder Limit: An S corporation cannot have more than 100 shareholders. If the number goes above this limit, the election is automatically terminated.
  • Ineligible Shareholders: Only certain types of shareholders are permitted (e.g., individuals, some trusts, and estates). Corporations, partnerships, or nonresident aliens owning stock will invalidate the S election.
  • Second Class of Stock: An S corporation must have only one class of stock. Special allocation rights or differing distributions can be interpreted as creating a second class.
  • Excess Passive Investment Income: If the corporation has accumulated earnings and profits (E&P) from prior C corporation years and its passive investment income exceeds 25% of gross receipts for three consecutive tax years, the S election may terminate.

Voluntary Termination of an S Corporation

To voluntarily terminate an S corporation's status requires a vote by the shareholders. Any combination of shareholders that make up 50 percent of the outstanding stock must be in agreement to terminate S corporation status. 

The following steps are taken once an agreement to terminate is reached.

  • A statement detailing the number of shares issued and any outstanding as of when the vote on S corporation status was taken must be written.
  • The statement will identify the shareholders and how they voted regarding termination and the number of shares owned when the vote took place.
  • Each shareholder named in the statement must sign the statement.
  • Once signed, the statement is submitted to the Internal Revenue Service.

For a business that has a shareholder who owns 51 percent, that shareholder can compel the termination of the S corporation status.

Consequences of Termination of Status

On the day the S corporation status is terminated the business will begin to be taxed as a C corporation. 

Once the status changes from S to C, two things happen regarding taxes. First, the business will have a shortened tax year that will be filed for the time the business was an S corporation. The second change requires that a second tax return will need to be filed for the remainder of the year the business operates as a C corporation.

Filing two tax returns and the allocation of the income and expenses for the year between the two forms may cause additional tax burdens for shareholders. This will be due to any payments by the corporation the shareholders once the S status is terminated becomes a taxable item for shareholders when filing their taxes.

The corporation will have to begin paying taxes on its income. This will begin with the C corporation's shortened year's tax return.

Considerations in the Termination of Status

  • To protect against involuntary termination, enter into a shareholder's agreement. An agreement serves to minimize the possibility of a shareholder leaving the business and selling their shares to someone who does not meet the requirements and could jeopardize the S corporation status.
  • Oversee the passive income to total income of the corporation to ensure it does not surpass the 25 percent maximum for revenues earned from passive income over three successive years.

Preventing Involuntary Termination of S Corporation Status

To minimize the risk of an involuntary termination of S corporation status, consider implementing the following practices:

  • Regular Eligibility Reviews: Annually verify that shareholders, stock structure, and income levels remain compliant with S corp rules.
  • Shareholder Agreements: Establish binding agreements that restrict transfers to eligible shareholders only.
  • Document Audits: Have legal counsel periodically review corporate documents for provisions that may conflict with S corporation regulations.
  • Monitor Passive Income: Maintain records and proactively limit passive income levels if the corporation has E&P.

Proactive compliance helps preserve S corporation benefits and avoids costly reclassification as a C corporation.

Document Provisions That Risk S Status

Certain corporate documents may unintentionally lead to the loss of S status. Common issues include:

  • Buy-Sell Agreements: Clauses that allow transfers of stock to non-qualified entities (e.g., corporations, partnerships) can cause termination.
  • Redemption Rights or Call Options: These may create a second class of stock if they affect shareholders' distribution rights.
  • Operating Agreements: Provisions that allocate profits or losses unequally could be seen as creating multiple classes of stock.

Reviewing and updating corporate documents post-S election is essential to ensure continued compliance with IRS requirements.

Frequently Asked Questions

1. What happens if my S corporation unintentionally violates IRS rules? If the violation is deemed inadvertent and corrected promptly, the IRS may grant relief to preserve S corporation status.

2. Can a nonresident alien become a shareholder in an S corporation? No, doing so will trigger an automatic termination of the S election, as only U.S. persons may be shareholders.

3. What is considered passive investment income for S corporations? Passive income includes rent, dividends, interest, and royalties—essentially income from activities not directly tied to business operations.

4. Is it possible to regain S corporation status after termination? Yes, but the company must wait five years unless the IRS grants permission for early re-election.

5. How can I avoid the involuntary termination of S corporation status? By limiting passive income, reviewing shareholder eligibility, ensuring stock complies with the one-class rule, and updating legal documents accordingly.

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