Elections available to S corporations with significant ownership changes.

• Author: Marquez, Mark

S corporations are flowthrough entities, and pertinent items of income and expense are allocated to shareholders on a per share per day basis. When there are no changes in ownership during a tax year, that allocation can often be overlooked. However, for S corporations that undergo ownership changes, tax elections are available to allocate income and expenses to shareholders to take into account the shifting of ownership during the tax year. In the event of a complete termination of a shareholder's interest, the availability of an election under Sec. 1377(a)(2) to close the tax year is well known to CPAs. A lesser known election under Regs. Sec. 1.1368-1 (g) is similar to the Sec. 1377(a) (2) election but has certain distinctions outlined below. This item examines why shareholders arc typically motivated to request one of these elections and addresses why tax advisers should raise the question of the election at the time of ownership change and nor at a later date. The following paragraphs will compare the situations in which elections under Sec. 1377(a)(2) and Regs. Sec. 1.1368-l (g) are applicable and the practical issues encountered when these elections are addressed at some point after the transaction date.

In the absence of a Sec. 1377(a)(2) or Regs. Sec. 1.1368-l (g) election, items of income and expense for the entire year of the ownership change arc divided by 365 days (366 in a leap year) to calculate the per day amount. The per share amount is calculated based on their ownership on each day in the year. If no election is made, there is no closing of the books to allocate income and expense disproportionately to follow the disproportionate ownership during the tax year. The total of prechange income and post-change income is spread evenly over the 365 days.

Sec. 1377(a)(2) applies to situations in which a shareholder terminates his or her complete interest in the S corporation. This does not apply when a new shareholder is admitted or acquires more stock during the tax year. While still following the per share per day rule, a Sec. 1377(a) (2) election causes the corporation to calculate a shareholder's share of income and expense as if the year consisted of two tax years (or more if there is more than a single termination during the year): one before the termination and the other after the termination. This closing of the books causes the income and expense for a period to be allocated only to shareholders owning shares during that period.

In contrast, the lesser-known Regs. Sec. 1.1368-l (g) election applies when (1) a shareholder...