The termination of an S Corporation election may result from a specific revocation by its shareholders or from a intentional or inadvertent act. If more than one-half of the shareholders, consent to revoke an S election (specific revocation), the revocation will be deemed to occur on either of two dates. Pursuant to Sec. 1362(d)(1)(c), if a revocation is made on or before the fifteenth day of the third month of the current taxable year, the revocation is effective on the first day of the taxable year. If it occurs after the fifteenth day of the third month, then it is effective on the first day of the following year. Alternatively, the shareholders may specify a particular prospective date during the tax year in which the revocation will take place. This would cause a split in the tax year between the S period and the C period.

In an inadvertent termination occurs and is not cured, it will also force the tax year to be split between the S period and the C period. One way an inadvertent termination may occur is if passive investment income of an S Corporation exceeds 25% of gross receipts for three consecutive taxable years and such corporation has subchapter C earnings and profits. The termination in this case is effective on and after the first day of the taxable year following the third consecutive year in which the 25% threshold is exceeded Sec. 1362(d)(3)(A).

Other Inadvertent Terminations

Other events may cause an inadvertent termination of an S Corporation election during the taxable year resulting in a split period, for example:

* The number of allowable shareholders excees 35;

* Stock is transferred to an ineligible shareholder (i.e., a corporation, partnership, ineligible trust, or nonresident alien);

* There is an issuance of a second class of stock; or

* There is an acquisition of an 80% or more owned subsidiary (other than a non-operating subsidiary).

The IRS has carved out some notable exceptions relating to monetary ownership by an S Corporation or ineligible shareholder. In Rev. Ruls. 72-320 and 73-496 respectively, the IRS ruled that an S Corporation's monentary ownership of stock in another corporation in connection with either a reorganization under Sec. 368(a)(1)(D) or an acquisition followed by a liquidation, would not terminate the S election. Further, the IRS issued PLR 8926016 and extended the result of Rev. Rul. 72-320 to partnership ownership. It allowed two partnerships that incorporated under Sec. 351(a) to momentarily own the stock of such newly established S Corporation.

If any of these events occur and result in an inadvertent termination of the S Corporation election, Prop. Reg. Sec. 1.1362-3(c)(1) requires the corporation to immediately notify the IRS Center with which the S Corporation election was filed. The notification should explain the cause of the termination and the date it occurred.

Pursuant to Prop. Reg. Sec. 1.1362-4(a), a termination that takes place during the taxable year on a day other than the first day of the taxable year creates an S termination year. The portion of the S termination year ending on the last day prior to the effective date of termination is referred to as the S short year. The remaining portion of the taxable year is referred to as the C short year. The effective date of termination is generally on and after the day the terminating event takes place.

Exceptions to Daily Proration

The corporation is generally required to allocate any income, gain, loss, deduction, or credit pro rata on a daily basis to the S short year and the C short year. However, there are three exceptions to this requirement. The first exception applies if all shareholders in the corporation at any time during the S short year and all shareholders in the corporation on the first day of the C short year consent to elect out of this pro rata rule. In such an instance, Prop. Reg. Sec. 1.1362- 4(c)(1) requires a separate closing of the books and records of the corporation. All items of income, gain, loss, deduction, and credit are allocated to the respective short years based upon the corporation's method of accounting. The election statement must describe the cause of the termination and the date it occurred. It must also be filed with the C short year return. The second exception applies if another corporation purchases the S Corporation and elects to treat the purchase of such stock as an asset acquisition pursuant to Sec. 338. Again, there must be a closing of the books and records.

Finally, if at any time during the termination year, 50% or more of an S Corporation's stock becomes "newly owned stock" as a result of sales or exchanges of such stock, then the corporation must close its books and records and compute income or loss under its method of accounting. Generally, newly owned stock is computed by comparing the percentage of the corporation's stock owned by a shareholder on the last day of the taxable year immediately preceding the S termination year and the percentage of stock owned by such shareholder after such sale or exchange. The increase in stock held by such shareholder will be considered towards the 50% change. For example, Mr. A owns all of the issued and outstanding shares of stock in a calendar year S Corporation. On March 15, 1989, Mr. A sells 90% of his stock to Mr. T. On July 30, 1989, Mr. A sells his remaining 10% to a partnership. The s Corporation election terminates on July 30, 1989, because the partnership is an ineligible shareholder. The stock held by Mr. T and the partnership is considered newly owned stock because Mr. T and the partnership did not hold such stock on December 31, 1988. Based upon the fact that 100% of the stock is treated as newly owned Stock, the corporation must make a separate closing of its books and records on July 30, 1988, and compute the S and C short year taxable income under the corporation's method of accounting. Prop. Reg. Sec. 1.1362-4(c)(4).

Once the taxable income is determined for each short period, a tax liability for the C short year must then be computed. The tax for the C short year is computed by annualizing the taxable income and applying the corporation rate brackets. This amount is then prorated by taking the number of days in the C short year and dividing it by the numbers of days in the termination year to arrive at the C short year tax liability. The alternative minimum tax is also computed by annualization, but on a monthly basis pursuant to Sec. 443(d).

Tax Returns Due at Same Time

The tax returns for both the S and C short years are due at the same time. This is normally the extended due date of the tax return for the yar in which the termination occurred. For example, if the termination occurs on September 30, 1989 for a calendar year S Corporation, the S and C short year returns are due March 15, 1990. They may be extended to September 15, 1990.

The S and C short tax years are treated as two separate years for all provisions of the Code except for carryback or carryforward purposes. In such a case, they will be considered one year. This can have an impact on carryforward items that are nearing expiration.

The rules may be avoided and the corporation's status as an S Corporation continued if the corporation corrects the event that caused the inadvertent termination and the Commissioner determines that such termination was inadvertent. The S Corporation must ake steps to correct the event within a reasonable period of time after it is discovered, and the corporation and shareholders must agree to any adjustments that the Commissioner may require for such period.