IRC 1362: S Corporation Election and Termination Rules

Internal Revenue Code (IRC) Section 1362 is the federal tax law governing the lifecycle of an S corporation’s tax status. The code dictates how a small business corporation can elect to be treated as an S corporation for federal tax purposes and outlines the procedures for making this choice. Beyond the initial election, IRC 1362 also details how this status can be ended through voluntary shareholder revocation or automatic involuntary termination. The law provides a pathway for corporations to regain S status after an accidental termination and addresses the waiting period required before a corporation can re-elect S status after a termination.

Making the S Corporation Election

To become an S corporation, a business must file Form 2553, “Election by a Small Business Corporation,” with the Internal Revenue Service (IRS). This form requires the corporation’s legal name, mailing address, Employer Identification Number (EIN), and the state and date of incorporation.

Form 2553 also requires a shareholder consent statement. Every individual who owns stock on the day the election is made must consent by providing their name, address, Social Security Number (SSN), and details of their stock ownership, including the number of shares and the dates they were acquired. Each shareholder must personally sign and date the consent statement.

Filing Form 2553 is subject to deadlines. To be effective for the current tax year, the form must be filed no more than two months and 15 days after the beginning of that tax year. For a new corporation, this period begins on the date the corporation first has shareholders, acquires assets, or begins doing business. If the deadline is missed, the election will not be effective until the following tax year.

The IRS provides a path for relief from a late filing. Revenue Procedure 2013-30 offers a simplified method for certain corporations to obtain late election relief without requesting a formal private letter ruling. To qualify, the corporation must have had reasonable cause for its failure to file on time and must file Form 2553 within three years and 75 days of the intended effective date.

Terminating the S Corporation Election

An S corporation election remains in effect until terminated. This can happen in two ways: a voluntary revocation by shareholders or an automatic, involuntary termination. A voluntary revocation requires the consent of shareholders who hold more than one-half of the corporation’s stock.

When submitting a revocation, the corporation must notify the IRS and can specify an effective date. If filed within the first two months and 15 days of the tax year, a revocation can be retroactive to the beginning of that year. If filed after that date, it is effective for the following tax year unless a future date is specified.

An involuntary termination occurs automatically when the corporation no longer qualifies as a small business corporation. Events that trigger termination include:

• Exceeding the 100-shareholder limit.
• Transferring stock to an ineligible shareholder, such as a corporation, a partnership, or a non-resident alien.
• Creating a second class of stock, which involves differences in distribution or liquidation rights.
• Having passive investment income (like rents, royalties, and interest) that is more than 25% of gross receipts for three consecutive years, but only if the corporation has accumulated earnings and profits from when it was a C corporation.

Seeking Relief for Inadvertent Terminations

If an S election is terminated unintentionally, the IRS may disregard the event if the termination was “inadvertent.” This relief is not automatic and requires the corporation to show the termination was accidental and not part of a tax avoidance plan.

To qualify for relief, the corporation must prove the termination was unintentional and take corrective action to restore its compliance within a reasonable period after discovering the event. For example, if stock was transferred to an ineligible shareholder, the corporation would need to arrange for its transfer back to an eligible one.

The corporation and all shareholders during the termination period must also agree to any adjustments required by the IRS. These adjustments treat the corporation as if the S election had been in effect continuously, ensuring income is reported consistently and preventing any tax advantage.

Requesting relief for an inadvertent termination is done by submitting a private letter ruling (PLR) request to the IRS. This is a formal, written request that details the facts and circumstances surrounding the termination and the steps taken to correct it. Submitting a PLR request involves a user fee that can be tens of thousands of dollars, depending on the corporation’s revenue.

Re-electing S Corporation Status After Termination

If an S corporation election is terminated and inadvertent termination relief is not granted, the corporation is barred from making a new election for a specific period. The law imposes a five-year waiting period before the corporation, or any successor corporation, can re-elect S corporation status. This five-year clock starts on the first day of the tax year following the year in which the termination took effect.

While this waiting period is the standard rule, the IRS has the authority to grant consent for an earlier re-election. The corporation has the burden of proof to convince the IRS that an early re-election is warranted.

One of the primary situations where the IRS may permit an early re-election is when there has been a significant change in the corporation’s ownership. If persons who owned more than 50% of the corporation’s stock on the date of termination no longer own a majority stake, the IRS tends to view this favorably. The logic is that the new ownership group should not be penalized for the actions that led to the prior termination.

Consent for an early re-election might also be granted if the event causing the termination was not reasonably within the control of the corporation or its substantial shareholders. This could apply to situations where the termination was caused by an unforeseeable external event. If the corporation can demonstrate that the termination was not part of a plan to move in and out of S corporation status, the IRS may be more inclined to waive the five-year waiting period.