How to Revoke S Corp Election and What Happens Next
Learn the process of revoking an S Corp election and understand the tax implications and shareholder notifications involved.
Revoking an S Corporation election can profoundly affect business owners’ tax obligations and corporate structure. Understanding the process and implications is critical to ensuring compliance with IRS regulations and optimizing financial outcomes.
Circumstances That May Prompt a Revocation
Business owners may revoke their S Corporation election due to changes in financial conditions or strategic goals. For instance, as businesses grow, the tax advantages of S Corporation status may diminish. A company anticipating significant retained earnings might benefit from reverting to a C Corporation, which allows for more favorable tax treatment on undistributed profits under the current 21% corporate tax rate.
Another common reason is the need to raise capital. S Corporations face limitations, such as a 100-shareholder cap and restrictions on issuing multiple classes of stock, which can hinder fundraising efforts. Companies seeking venture capital or planning to go public often find these constraints restrictive. Revoking the S Corp election enables the issuance of preferred stock and expansion of the shareholder base, facilitating fundraising.
Operational changes, such as mergers or acquisitions, may also necessitate a revocation. If an S Corporation merges with a non-qualifying entity, its S Corp status is automatically terminated. Proactively revoking the election allows better control over the timing and tax implications of such transactions. Additionally, changes in ownership, such as the inclusion of non-resident alien shareholders, can disqualify a company from maintaining its S Corp status, prompting a strategic revocation.
Steps to Submit a Revocation Statement
To revoke an S Corporation election, businesses must prepare a revocation statement in line with IRS requirements. This statement, signed by shareholders owning more than 50% of the corporation’s shares, must express the intent to revoke S Corp status and specify the effective date. The chosen date determines the corporation’s tax treatment for the remainder of the fiscal year.
The statement must be submitted to the IRS Service Center where the corporation files its tax returns. To make the revocation effective in the current tax year, the statement must be filed by the 15th day of the third month of that year. For example, for the revocation to take effect in 2025, the filing deadline is March 15, 2025. Missing this deadline delays the effective date to the following tax year, potentially complicating tax planning.
Corporations should also update their articles of incorporation as necessary to reflect the change in tax classification. Keeping detailed records of the revocation process, including shareholder consents and IRS correspondence, is crucial to avoid disputes or audits later.
Post-Revocation Tax Classification
After revoking S Corporation status, the business typically defaults to a C Corporation unless another election is made. This transition introduces significant changes in taxation and financial operations. Under the C Corporation structure, the entity is subject to the 21% corporate income tax rate. Unlike S Corporations, C Corporations face double taxation, as dividends distributed to shareholders are taxed again at the individual level.
To manage this double taxation, businesses may retain earnings to fund growth initiatives, deferring the second layer of taxes. Alternatively, they might adopt tax-efficient strategies for distributing profits, such as issuing qualified dividends, which could be taxed at lower rates depending on the shareholder’s tax bracket.
The shift also alters compliance and reporting obligations. C Corporations file Form 1120, which requires detailed reporting on income, deductions, and credits, necessitating meticulous bookkeeping. Additionally, C Corporations must make estimated tax payments if they anticipate owing $500 or more for the year, as specified by IRS regulations.
Notifications to Shareholders
Clear communication with shareholders is essential during significant structural changes like revoking S Corporation status. Prompt notification ensures transparency and helps maintain trust, especially as these changes can impact shareholders’ tax situations. Notifications should explain the reasons for the revocation and how it aligns with the company’s strategic goals. They should also address any changes to shareholder rights, such as plans to issue new classes of stock or revised dividend policies.
Shareholders must understand how the transition affects their taxable income, particularly if they are accustomed to the S Corporation’s pass-through taxation model. The notification should encourage shareholders to consult tax advisors to assess the personal financial implications of the change.