Inadvertent S corp. terminations.

• Author: Elefonte, Phillip

Although limited liability companies are becoming the more popular choice of entity structure, S corporations are still a common entity choice. Therefore, it is important to stay current on the qualifications and ensure that the entity remains compliant. When an S election is made, requirements must be met to avoid an inadvertent termination of S status.

Terminations can be voluntary or involuntary; however, inadvertent involuntary terminations should be addressed immediately upon discovery. If the proper steps are taken, the IRS may grant a corporation relief and, subject to certain conditions, continue to treat the corporation as an S corporation.

S Corporation Requirements

S corporations are required under Sec. 1361(b) to meet the following criteria to qualify as a small business corporation:

* Be a domestic corporation.

* Have only allowable shareholders: individuals, certain trusts, and estates. Partnerships, corporations, or nonresident alien shareholders cannot be shareholders.

* Have no more than 100 shareholders.

* Have one class of stock.

* Not be an ineligible corporation, i.e., certain financial institutions, insurance companies, and domestic international sales corporations.

Involuntary Terminating Events

An S corporation election may be terminated involuntarily if the entity ceases to qualify as a small business corporation or its passive income exceeds the passive income limitation. An S corporation ceases to qualify as an S corporation if it does not meet the criteria in Sec. 1361(b) discussed above. A termination for this reason can be considered to be inadvertent, as discussed below.

Passive income exceeds the passive investment income limitation if the S corporation has accumulated earnings and profits at the close of each of three consecutive tax years (this would occur only if the corporation or its predecessor had been a C corporation) and has gross receipts for each of those tax years, more than 25% of which are passive investment income (Sec. 1362(d)(3) and Regs. Sec. 1.1362-2(c)).

A corporation's S election terminates effective on the date that the company commits the act that triggers the ineligibility. If a corporation elects to become an S corporation effective the beginning of its next tax year, and the corporation does not qualify as an S corporation on the first day of its next tax year, its election is treated as terminating that day. After a termination, the corporation is not eligible to elect S status for...