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 S status can be rescinded by the Internal Revenue Service (IRS) or the shareholders of the corporation can choose to give it up.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 they 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.

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.

If you need help with the termination of S corporation status, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.