Consequences of S corporation termination in a reorganization.

• Author: Ellentuck, Albert B.

AN S CORPORATION CAN PARTICIPATE AS a corporate entity in a corporate reorganization (see the conference committee report to Section 1310 of the Small Business Job Protection Act, H.R. Conf. Rep't No. 737, 104th Cong., 2d Sess. 226 (1996)). This leads to a substantive advantage of S corporations over partnerships: S corporations and their shareholders can accomplish stock exchanges, corporate divisions, mergers, and the other forms of transactions known as tax-free reorganizations, whereas subchapter K of the Code provides no such opportunity for partnerships. However, an S corporation participating, in one of these transactions can face the loss of its S status in a number of ways--if, for example, any of its stock is owned by another corporation.

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Termination of S Status in Type A, B, or C Reorgs.

If an S corporation is merged or consolidated out of existence in a type A reorganization, its S status will cease. If the S corporation is the acquiring corporation, it can lose S status by exceeding the maximum shareholder limitation, adding an ineligible shareholder, or absorbing a corporation with outstanding stock or debt that constitutes a prohibited second class of stock. Furthermore, it can acquire assets (or earnings and profits) from the target corporation that lead to excess net passive investment income and termination of S status after three consecutive years.

If the S corporation is the acquired corporation in a type B stock-for-stock reorganization, it can lose its S status because it has a corporate shareholder or goes out of existence in a subsequent liquidation.

If the S corporation is the acquiring corporation in a type C reorganization, it can lose its S status because of the existence of a corporate shareholder. However, this risk can be avoided if the stock is transferred to the shareholders of the target corporation. As an alternative, the S corporation can liquidate the target, in which case the "transitory subsidiary" exception should protect its S election. Other risks include gaining, an ineligible shareholder, exceeding the shareholder limitation, assuming nonqualifying debt, or acquiring assets (or earnings and profits) from the target that lead to excess net passive investment income and termination of S status after three consecutive years.

If the S corporation is the acquired corporation, it generally will be liquidated following the reorganization, although the IRS has the authority to waive...