Business Entities · S corporations

Revocation, termination and reinstatement

An election ends in one of three ways, and only the first is deliberate. The two that are not share a feature worth internalising early: they take effect on the day the disqualifying fact occurs, not at the end of the year in which someone notices.

The rule

Revocation. more than one-half of the shares of stock of the corporation on the day the revocation is made must consent — counting shares, not shareholders, and counting non-voting shares^TY2026 (IRC § 1362(d)(1)(B)). And a revocation made on or before the 15th day of the 3rd month of the taxable year is effective on the first day of that year; one made after that day is effective on the first day of the following year; and a revocation that specifies a date on or after the day it is made is effective from the date specified^TY2026 (IRC § 1362(d)(1)(C), (D)).

Ceasing to qualify. the election terminates whenever the corporation ceases to be a small business corporation, effective on and after the date of cessation^TY2026 (IRC § 1362(d)(2)). Any failure of the IRC § 1361(b) requirements will do it — an ineligible shareholder, a 101st shareholder, a second class of stock — and the effective date is the date of the failure.

Passive investment income. the election terminates where the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years and, for each of those years, more than 25 percent of gross receipts is passive investment income; it is effective on the first day of the year beginning after the third such year^TY2026 (IRC § 1362(d)(3)(A)). Two conditions, both required, for three consecutive years. gross receipts derived from royalties, rents, dividends, interest and annuities — excluding interest on an obligation acquired in the ordinary course of business from the sale of inventory property, certain lending and finance receipts, dividends from a controlled C corporation attributable to its active business earnings, and bank interest and required-holding dividends^TY2026 (IRC § 1362(d)(3)(C)), and on a disposition of a capital asset other than stock or securities, gross receipts count only to the extent of the capital gain net income; on a sale or exchange of stock or securities, only to the extent of the gains^TY2026 (IRC § 1362(d)(3)(B)).

The year of the break. any taxable year in which a termination takes effect other than on the first day of the year; it is split into an S short year ending before the effective day and a C short year beginning on it^TY2026 (IRC § 1362(e)(4), (e)(1)). Items are split: the items of income, loss, deduction and credit for the whole S termination year are determined first and then assigned in equal portions to each day of that year^TY2026 (IRC § 1362(e)(2)), unless the corporation may elect out of the daily allocation and assign items under normal tax accounting rules, but only if every person who was a shareholder at any time during the S short year and every person who is a shareholder on the first day of the C short year consents^TY2026 (IRC § 1362(e)(3)) — and the daily allocation does not apply at all to an S termination year in which there is a sale or exchange of 50 percent or more of the stock — the books close whether or not anyone elects^TY2026 (IRC § 1362(e)(6)(D)).

Relief. where the Secretary determines the circumstances were inadvertent, steps were taken within a reasonable period after discovery to qualify or to obtain the consents, and the corporation and every shareholder for the period agree to the adjustments required, the corporation is treated as an S corporation throughout the period the Secretary specifies^TY2026 (IRC § 1362(f)).

Coming back. a corporation whose election has terminated, and any successor corporation, may not elect again before its 5th taxable year beginning after the first taxable year for which the termination was effective, unless the Secretary consents^TY2026 (IRC § 1362(g)).

Current figures

How it works in practice

Count shares, not heads. more than one-half of the shares of stock of the corporation on the day the revocation is made must consent — counting shares, not shareholders, and counting non-voting shares^TY2026 (IRC § 1362(d)(1)(B)). The contrast with the election is deliberate and is examined constantly: an election under IRC § 1362(a) needs the consent of every shareholder, while a revocation needs the consent of holders of more than half the shares. Non-voting shares count in the denominator and in the numerator, so a shareholder holding a majority of a non-voting block can revoke over the objection of the voting holders.

A revocation has three possible effective dates. a revocation made on or before the 15th day of the 3rd month of the taxable year is effective on the first day of that year; one made after that day is effective on the first day of the following year; and a revocation that specifies a date on or after the day it is made is effective from the date specified^TY2026 (IRC § 1362(d)(1)(C), (D)). The 15th-day-of-the-third-month line is the same line that governs a late election, and for the same reason: it is the point past which retroactivity to the start of the year is no longer available. The prospective-date rule of IRC § 1362(d)(1)(D) is the escape, and it is why a well-advised revocation almost always names its own date.

Disqualification is instantaneous. the election terminates whenever the corporation ceases to be a small business corporation, effective on and after the date of cessation^TY2026 (IRC § 1362(d)(2)). Transfer one share to a partnership on 3 April and the election is gone from 3 April. Nothing about the corporation’s intentions, and nothing about when the transfer is discovered, changes that. The remedy is IRC § 1362(f), not a re-reading of IRC § 1362(d)(2).

The passive income test needs both limbs, three years running. the election terminates where the corporation has accumulated earnings and profits at the close of each of 3 consecutive taxable years and, for each of those years, more than 25 percent of gross receipts is passive investment income; it is effective on the first day of the year beginning after the third such year^TY2026 (IRC § 1362(d)(3)(A)). A corporation with no accumulated earnings and profits can hold nothing but municipal bonds indefinitely and never terminate on this ground — the first limb is never satisfied. That is the single most common error on this rule, and it is worth saying to yourself in the negative: no accumulated earnings and profits, no termination under IRC § 1362(d)(3).

Watch the gross receipts arithmetic. on a disposition of a capital asset other than stock or securities, gross receipts count only to the extent of the capital gain net income; on a sale or exchange of stock or securities, only to the extent of the gains^TY2026 (IRC § 1362(d)(3)(B)). A corporation that sells a building at a gain adds only the gain to gross receipts, not the sale price. Because the fraction is passive receipts over total receipts, using the gross sale price would drown the passive income and produce the wrong answer.

Split the year of the break. any taxable year in which a termination takes effect other than on the first day of the year; it is split into an S short year ending before the effective day and a C short year beginning on it^TY2026 (IRC § 1362(e)(4), (e)(1)). Two returns, and the return for the S short year is due on the same date as the return for the C short year, including extensions^TY2026 (IRC § 1362(e)(6)(B)) — so the S short year return is pulled forward to the C corporation’s date rather than keeping the 1120-S date. The default allocation is the items of income, loss, deduction and credit for the whole S termination year are determined first and then assigned in equal portions to each day of that year^TY2026 (IRC § 1362(e)(2)), which is a daily average and ignores when the income actually arose. The corporation may elect out, but the corporation may elect out of the daily allocation and assign items under normal tax accounting rules, but only if every person who was a shareholder at any time during the S short year and every person who is a shareholder on the first day of the C short year consents^TY2026 (IRC § 1362(e)(3)) — every shareholder on either side of the line, which is a harder consent to collect than it sounds when the termination was caused by a shareholder who has since gone.

One case closes the books without an election. the daily allocation does not apply at all to an S termination year in which there is a sale or exchange of 50 percent or more of the stock — the books close whether or not anyone elects^TY2026 (IRC § 1362(e)(6)(D)). Where half or more of the stock changes hands in the termination year, the daily allocation is switched off by the statute itself.

Relief is available and is used constantly. where the Secretary determines the circumstances were inadvertent, steps were taken within a reasonable period after discovery to qualify or to obtain the consents, and the corporation and every shareholder for the period agree to the adjustments required, the corporation is treated as an S corporation throughout the period the Secretary specifies^TY2026 (IRC § 1362(f)). Note the four conditions, and note in particular the last: every shareholder for the period must agree to whatever adjustments the Secretary requires. Relief is discretionary and is sought by private letter ruling.

Coming back takes five years, or the Secretary’s consent. a corporation whose election has terminated, and any successor corporation, may not elect again before its 5th taxable year beginning after the first taxable year for which the termination was effective, unless the Secretary consents^TY2026 (IRC § 1362(g)). The clock runs from the first taxable year for which the termination was effective, and it reaches a successor corporation, so a reorganisation does not reset it.

How this has changed

The two conversion reliefs enacted in 2017 are now closed to new entrants. Pub. L. 115-97 § 13543 added IRC § 481(d) and IRC § 1371(f), both keyed to an “eligible terminated S corporation.” That term is defined in IRC § 481(d)(2) as a C corporation that was an S corporation on 21 December 2017 and revoked its election during the two-year period beginning 22 December 2017, whose stock on the date of revocation was held by the same owners in identical proportions as on 22 December 2017^TY2026. The window it describes ran for two years from the enactment date and closed on 21 December 2019. No corporation can qualify now, and none ever will — but the two reliefs remain live law for the corporations that did.

For those corporations, a IRC § 481(a)(2) adjustment attributable to the revocation is taken into account ratably over the 6-taxable year period beginning with the year of change^TY2026 (IRC § 481(d)(1)) — so a change from the cash method forced by the conversion is spread over six years rather than the usual four. And on a distribution of money by an eligible terminated S corporation after the post-termination transition period, the accumulated adjustments account is allocated to the distribution, and the distribution is charged to accumulated earnings and profits, in the same ratio as the account bears to those earnings^TY2026 (IRC § 1371(f)), which is a genuine departure from ordinary subchapter C treatment: after the post-termination transition period, a distribution of money is charged proportionately to the accumulated adjustments account and to accumulated earnings and profits, rather than being a dividend to the extent of earnings and profits. An eligible terminated S corporation therefore never loses the whole of its account, while an ordinary former S corporation does once the period under IRC § 1377(b) runs out.

The practical consequence is a two-tier rule that a reader will not find in any summary of “what happens when an S election ends.” Which tier applies turns entirely on facts fixed in December 2017, and the page states the general rule first for that reason.

Exam focus

The highest-yield distinction here is between the consent required to elect and the consent required to revoke. Learn it as a pair, and learn that revocation counts shares rather than votes or heads.

The second is the two-limb structure of the passive investment income test. Read any question on it by asking about accumulated earnings and profits first; if the facts do not supply them, the rest of the question is a distractor.

The third is the S termination year. Know that it produces two short years with one due date, that the default is a daily allocation, that the election out needs consent from both sides of the line, and that a change of half or more of the stock makes the close mandatory.

Finally, hold IRC § 1362(f) and IRC § 1362(g) together: relief is available for an inadvertent termination, and where relief is not obtained the corporation waits five years. Questions frequently present a termination and ask what the corporation can do — the answer is almost always one of those two provisions.

Check yourself

1. A corporation has four shareholders holding 100, 100, 100 and 700 shares. The holder of 700 shares wants to revoke the election; the other three object. Can the election be revoked?

Answer: Yes. more than one-half of the shares of stock of the corporation on the day the revocation is made must consent — counting shares, not shareholders, and counting non-voting shares^TY2026 700 of 1,000 shares is more than one-half, and the number of shareholders consenting is irrelevant. Contrast the election itself, which requires the consent of every shareholder on the day it is made.

2. An S corporation with no C corporation history derives 90 percent of its gross receipts from dividends and interest for five consecutive years. Does the election terminate?

Answer: No. IRC § 1362(d)(3)(A)(i) requires accumulated earnings and profits at the close of each of three consecutive years as well as excess passive investment income, and a corporation that has always been an S corporation has none — IRC § 1371(c) prevents it from creating any.

3. An S corporation sells a warehouse for $1,800,000, realising a gain of $250,000, and has $400,000 of rents and $150,000 of operating receipts in the same year. What are its gross receipts for the passive income test, and what is the passive percentage?

Answer: on a disposition of a capital asset other than stock or securities, gross receipts count only to the extent of the capital gain net income; on a sale or exchange of stock or securities, only to the extent of the gains^TY2026 so the sale contributes $250,000, not $1,800,000. Gross receipts are $800,000, of which $400,000 of rents is passive — 50 percent, above the threshold. Using the sale price would give $2,350,000 and 17 percent, and the wrong answer.

4. An election terminates on 1 September. Sixty percent of the stock was sold to a new investor in March of the same year. May the corporation use the daily allocation of IRC § 1362(e)(2)?

Answer: No. the daily allocation does not apply at all to an S termination year in which there is a sale or exchange of 50 percent or more of the stock — the books close whether or not anyone elects^TY2026 (IRC § 1362(e)(6)(D)). The sale of 50 percent or more of the stock during the S termination year switches the daily allocation off by force of statute, so the books close whether or not anyone elects.

5. A corporation’s election terminated with effect from 1 January 2026 because it acquired an ineligible shareholder, and no relief was sought. When is the earliest it may elect again without the Secretary’s consent?

Answer: For its taxable year beginning in 2031. a corporation whose election has terminated, and any successor corporation, may not elect again before its 5th taxable year beginning after the first taxable year for which the termination was effective, unless the Secretary consents^TY2026 — the fifth taxable year beginning after 2026, the first taxable year for which the termination was effective.