During the formation of an S-Corporation or the conversion to an S-Corporation, significant due diligence takes place to ensure the corporation is a valid S-Corporation for federal income tax purposes. However, without continued due diligence, your company could be at risk for losing its S election without realizing it. There are numerous business transactions that occur throughout the year that may inadvertently terminate a corporation’s S election. Even a transaction by a small minority shareholder could terminate the S election for the entire corporation. It’s important that you and your shareholders are aware of what actions may cause this to happen and take measures to prevent it.
You could terminate your S election if you have:
- More than 100 shareholders. While in a quest to raise additional capital, a corporation may find itself at odds with this S-Corporation restriction. In addition, if the corporation is close to the maximum, the corporation could run afoul when a shareholder transfers stock in a form of joint ownership because each joint owner, other than a family member, is a separate shareholder.
- An ineligible shareholder. S-Corporations cannot be owned by C-Corporations, partnerships, ineligible trusts, or non-resident aliens. Throughout the tax year, shareholders may sell their stock or transfer their stock to one of these ineligible shareholders. It’s important that all shareholders are aware of the ownership restrictions placed upon S-Corporations by the IRS. A buy-sell agreement is a good place to put restrictions on transfers of shares to ineligible shareholders.
- More than one class of stock. All outstanding shares of stock must confer identical rights to distribution and liquidation proceeds. Therefore, disproportionate distributions during the tax year could unintentionally terminate the corporation’s S election.
- Excess passive investment income. If an S-Corporation has accumulated earnings and profits from being a prior C-Corporation, its election will terminate if, for a period of three consecutive tax years, its “passive investment income” exceeds 25% of its gross receipts.
What Happens if it Does Terminate?
If, despite the corporation’s ongoing due diligence, the corporation’s election is inadvertently terminated, the IRS does have some relief measures in place to help mitigate the consequences. However, this can be a timely and costly process and all steps should be taken to avoid termination in the first place.
What Can I Do to Prevent it?
Year-end tax planning is a good time to conduct ongoing S-Corporation due diligence. Your Eide Bailly tax professional would be happy to discuss what steps you should take, any risk factors you may face and answer questions regarding inadvertent terminations.
