How an S Corporation Can Lose Its Status: Key Reasons and Tax Implications

An S corporation can lose (in other words, terminate) its special tax status in three main ways:

1. Too Much Passive Income: If an S corporation makes over 25% of its income from investments rather than its core business activities, and has leftover profits at the end of each of the last three years, it can lose its S corporation status.

   
   

2. Breaking the IRS Rules: An S corporation might violate the rules for maintaining its status by having more than 100 shareholders, issuing different types of stock, or including non-U.S. residents as shareholders. We talked about it here.

   
   

3. Voluntary Choice: Shareholders can decide to end the S corporation status. This happens when shareholders holding more than half of the company's shares agree to revoke the status and file the necessary paperwork with the IRS.

   
   

In any of these situations, revoking S corporation status—whether done intentionally or not—changes the entity to a C corporation. If this change occurs at a time other than the beginning or end of the tax year, it complicates things: the tax year must be split into a short S corporation year and a short C corporation year.

When an S corporation's status is terminated, the tax year ends on that same day. This doesn’t mean the business stops recording transactions; rather, it continues to log transactions and then divides income, losses, and other financials between the short S corporation year and the subsequent short C corporation year, using a pro-rata method based on the number of days in each year.

Example: Apex Design, an S corporation on a calendar year, ends its S corporation status on July 1. This results in a short S corporation year covering January 1 to June 30 and a short C corporation year from July 1 to December 31. Reviewing its financials shows that Apex Design had an $80,000 loss in the first half of the year and a $200,000 profit in the second half, totaling a net income of $120,000 for the year. The income is prorated between the two short years, so $60,000 of the income is reported for each short year.

An alternative method is to allocate income and expenses according to standard accounting practices, which requires unanimous agreement from all shareholders. This method involves reporting all income, losses, deductions, or credits based on the firm's financial records. Consequently, these items are divided based on the timing of their occurrence throughout the tax year. For instance, using this approach in the previous example would assign the $80,000 loss to the S corporation short year and the $200,000 gain to the C corporation short year.

If shareholders did not mean to end the S corporation status, they can take corrective measures to reinstate it within a reasonable time frame and inform the IRS of these actions. The IRS correspondence should detail the cause of the termination, how and when it was discovered, and the steps taken to address the issue. On the other hand, if the termination was intentional, shareholders must wait five years before they can reelect S corporation status, unless they try to seek and obtain IRS approval for an earlier re-election. The IRS is more likely to grant permission for an early re-election if the termination resulted from circumstances beyond the control of the business or its shareholders.

When an S corporation changes to a C corporation, it must follow the distribution rules for C corporations. However, there is a transition period after the termination during which different rules apply. During this time, distributions are treated as if they were made by an S corporation and maintain their tax-free status up to the shareholders’ adjusted basis in their S corporation stock. This transition period begins the day after the S corporation status ends and lasts until the later of the due date for the final S corporation return or one year after the termination date.

S Corp Liquidation: In the event of an S corporation's liquidation, the amounts distributed to shareholders are considered as full payment for their shares. The corporation must recognize any gain or loss on the property distributed, treating it as if it had sold its assets to the shareholders at their fair market value on the liquidation date. The basis of the distributed assets for the shareholders is their fair market value at the time of distribution. Additionally, the shareholders' stock basis will be adjusted according to the gain or loss recognized during the liquidation.

Example: Apex Design, an SCorp, has one shareholder, Alex. Initially, Apex purchased a building for $500,000 right after its incorporation. Four years later, the only asset Apex holds is this building, which now has a fair market value of $900,000 and a cost basis of $500,000. At the end of the year, Alex's stock basis is $350,000. Apex Design gets closed down and distributes the building to Alex. The SCorp recognizes a $400,000 gain (calculated as the $900,000 fair market value minus the $500,000 cost basis of the building) on its tax return. This gain is classified as long-term capital gain due to the long holding period. Alex reports this gain on his tax return and his stock basis increases to $750,000 (the original $350,000 plus the $400,000 gain). When Alex receives the building, valued at $900,000, he compares this to his adjusted stock basis of $750,000. He will then recognize an additional gain of $150,000 (the $900,000 fair market value minus the $750,000 adjusted basis). This additional gain is also considered a long-term capital gain, given the holding period.

Please note: If a shareholder lacks enough basis to absorb losses from the corporation's operations and the corporation liquidates, any remaining losses are permanently lost as of the liquidation date.

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