Termination of S Corporation Status for U.S. Federal Tax Purposes

As I have mentioned before, the S corporation is subject to certain restrictions.  For example, the S corporation may have only 100 or less shareholders.  In addition, it may only have certain types of shareholders.  These shareholders include individuals, estates, certain tax-exempt organizations, certain trusts, and individuals who are not nonresident aliens.  Further, it must only have one class of stock.   When an S corporation does not adhere to a restriction, its S corporation status is terminated.  This article addresses the consequences of termination of S corporation status.When an entity loses its S corporation status, the entity becomes treated for U.S. federal tax purposes as a C corporation.  In general, the S corporation’s tax year is deemed to end the day before the failure to adhere occurs and the C corporation’s tax year begins on the day of the failure to adhere.  A Form 1120S (U.S. Income Tax Return for an S Corporation) must be filed for the S corporation tax year that ended, and a Form 1120 (U.S. Corporation Income Tax Return) must be filed for the C corporation year that begun.Because the entity’s new status as a C corporation may result in unfavorable tax consequences, damage control may be necessary.  One option to minimize damage would be to elect to be treated as a partnership by “checking the box” on a Form 8832 (Entity Classification Election).  Nevertheless, this option may only apply if the entity is eligible to elect on a Form 8832.  An entity formed as a corporation, for example, is ineligible.  In addition, this option may not be available if the entity has made an election to change its classification within the previous 60 months and the election was not in effect on the date of formation of the entity.  Finally, turning a corporation into a partnership will involve a liquidation for tax purposes, and thus adverse tax consequences may result.Another option to minimize damage is to request from the Internal Revenue Service a ruling that the corporation should be taxed as an S corporation.  In this case, the taxpayer must prove that the S corporation termination was inadvertent and that steps have been taken to fix the problem.  For example, the corporation may get rid of the nonresident alien shareholder.  The main concern with this approach is that this type of ruling can be expensive.The final option to minimize damage is to elect again on Form 2553 to be an S corporation.  This option, however, requires IRS consent if the election is made for any tax year before the 5th tax year after the first tax year in which the termination took effect.*This document contains legal information, but does not contain legal advice.*This document has examined laws in effect in July 2011.