Business Owners Beware: The many ways to terminate your S Corporation Election

If you are a business owner, or are looking to start your company, a popular entity choice for tax purposes is an S corporation. The popularity of S Corporations is supported through the steady growth in the number of businesses making the election or conversion each year in the U.S.  However, the election can be somewhat fragile and if the requirements are not met (and upheld), the business could lose its S Corporation status. 

Making and maintaining an S Corporation election requires careful consideration of the various events that can terminate that election.  Unlike a partnership or C Corporation, S corporations have very strict requirements that must be met in order to keep their elections intact.

To provide a little background, the election for an entity to be treated as an S corporation is made by filing form 2553, Election by a Small Business Corporation.  This form may be filed any time prior to the year the election is to take effect, or no later than two months and fifteen days into the year in which the election is to take effect.  A late election may be allowed in some cases, though there is some additional documentation that needs to be provided with the filing of the 2553.

In order to obtain and maintain the S election, the entity must meet the following requirements:

Have no more than 100 shareholders (spouses, family members, and decedents estates all count as one)

Have no ineligible shareholders, including:

• Non-resident aliens
• Partnerships and Corporations
• Most types of trusts, although elections can be made permitting certain trusts to be a qualified shareholder 

• Having both voting and nonvoting stock will not violate this rule

Once the S election is made, not only do all three of these requirements continue to apply, but the S corporation needs to keep another rule in mind.  If the S corporation was previously a C corporation that has accumulated earnings and profits (AE&P) from prior years, and 25% of its gross receipts for three consecutive years are from passive investment sources, then it could have its S status automatically terminated.  Another way an S corporation could have AE&P is if it acquires a C corporation, since the AE&P would transfer with the change in ownership.

An S Corporation can take some steps to help ensure the continuity of its election.  It can

• Establish agreements that permit stock to be sold only to qualified shareholders,
• Closely monitor passive income ratios if having AE&P is a concern, and
• Reconsider changes to stock rights or capital structure. 

If the election is revoked, it can be five years before the entity would be permitted to reapply for S status. 

The requirements to establish and uphold an S Corporation can be confusing and we are ready to help. Learn more about structuring your business to reduce taxes and improve cash flow. Contact us at 216-831-0733.