{ Business Law | S corporations }
Avoiding Inadvertent Termination of the S Corporation Election
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By Alexandra J.C. Gregorski, MBA, JD and
John A. Sikora, JD
n S corporation election can be revoked with the consent of shareholders holding more than one-half of the shares of the corporation’s stock. [See Internal Revenue Code (IRC) § 1362(d)(1).] The election can also be terminated in circumstances in which the owners have no intent to do so. Some of these — with particular emphasis on situations in which limited liability companies (LLCs) have elected to be S corporations — are discussed in this article. Tax advisors should help educate S corporation clients about termination situations so clients will be more apt to timely consult with their advisors and avoid them.
Criteria for S corporation status
An S corporation may not have more than 100 shareholders, and shareholders may be only individuals, estates, certain trusts or certain exempt organizations. None of the individuals may be a nonresident alien. The corporation may not be an “ineligible corporation”1 as defined in IRC § 1361. An S corporation may not have more than one class of stock, which generally means that all shares of stock must confer identical rights to distribution and liquidation proceeds. the term “ineligible corporation” means any corporation which is (A) a financial institution which uses the reserve method of accounting for bad debts described in section 585, (B) an insurance company subject to tax under subchapter L, or (C) a DISC or former DISC. 1
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Whether all outstanding shares of stock do so is generally based on the entity’s “governing provisions.”2 Differences in voting rights among shares of stock are disregarded in determining whether the corporation has more than one class of stock.
Avoiding the inadvertent termination of the S corporation election Failing to meet any of the S corporation requirements results in the termination of the S election. [See IRC § 1362(d)(2).] Recognizing and helping clients avoid events that will terminate the S status is often quite straightforward, such as with respect to application of the 100-shareholder and type-of-shareholder limitations. As to the former, most clients are aware of the limit and seek counsel before issuance of stock to a larger number of owners. As to the latter, avoiding an inadvertent termination is, in some measure, often accomplished by proper provisions 2 Treas. Reg. 1.1361-1(l).
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