Avoiding inadvertent termination of an S election.

• Author: Hunley, Shaun M.

If an S corporation fails to maintain its status as a "small business corporation" under Sec. 1361(b), its S election automatically terminates on the date the disqualifying event occurs. The disqualifying events that can terminate S status include the following (Secs. 1362(d)(2) and 1361(b)(1); Regs. Sec. 1.1362-2(b) (1)):

* Having more than 100 shareholders. The S corporation can have more than 100 shareholders in total during the year as long as there are no more than 100 shareholders at any given time.

* Having an ineligible shareholder (e.g., a corporation, partnership, ineligible trust, or nonresident alien). Partnership and corporate shareholders generally are not permitted, other than so-called transitory ownership as part of a corporate reorganization.

* Having more than one class of stock. Differences in voting rights are allowed, which can be useful, for example, when transferring nonvoting common stock to younger family members or trusted employees.

* Becoming an ineligible corporation such as an insurance company or a domestic international sales corporation.

* Transferring place of incorporation to a foreign country (thus no longer qualifying as a domestic corporation).

The IRS issued technical advice stating that a corporation's S election was not terminated by using an impermissible tax year (Technical Advice Memorandum 9505003). Sec. 1362 provides the specific events that can cause a corporation to fail to meet the definition of a small business corporation. Filing income tax returns based on an improper year end is not an event under Sec. 1362 that causes disqualification.

The IRS privately ruled that a corporation that qualified as an S corporation under Sec. 1361(b) prior to a state's administrative dissolution (when the corporation failed to timely file its annual report and pay its annual license fee) was not required to file a new S election under Sec. 1362(a) (IRS Letter Rulings 9411040 and 200835002). Similarly, an S corporation that did not know it had been administratively dissolved for the nonpayment of fees was not required to file a new election. The corporation had continued to file Form 1120-S, U.S. Income Tax Return for an S Corporation, and later reincorporated (IRS Letter Ruling 201237001).

In another letter ruling, the corporation filed a final tax return but took no action to dissolve itself. Later, the state administratively dissolved but retroactively reinstated the corporation. Based on conflicting...