Question

Explain the tax effects that might be realized due to a termination of an S Corporation Status.

Answer 1

S corporation status is an IRS-sanctioned tax designation that allows a corporation to retain liability protection for its shareholders but lets them be taxed like a partnership.This means that the S corporation is not taxed directly, but its shareholders add their share of the business’s annual income and losses to their personal returns and personally pay taxes on those amounts. To choose this status, the corporation must have fewer than 100 shareholders and cannot have any nonresident alien shareholders. It can only have one class of stock and cannot participate in certain industries. A corporation can have its S-corp status rescinded by the IRS or its shareholders can choose to give it up.

Consequences of Termination of Status

On the day the S corporation status is terminated the business will begin to be taxed as a C corporation.

Once the status changes from S to C, two things happen regarding taxes. First, the business will have a shortened tax year that will be filed for the time the business was an S corporation. The second change requires that a second tax return will need to be filed for the remainder of the year the business operates as a C corporation.

Filing two tax returns and the allocation of the income and expenses for the year between the two forms may cause additional tax burdens for shareholders. This will be due to any payments by the corporation the shareholders once the S status is terminated becomes a taxable item for shareholders when filing their taxes.

The corporation will have to begin paying taxes on its income. This will begin with the C corporation's shortened year's tax return.

Considerations in the Termination of Status

• To protect against involuntary termination, enter into a shareholder's agreement. An agreement serves to minimize the possibility of a shareholder leaving the business and selling their shares to someone who does not meet the requirements and could jeopardize the S corporation status.
• Oversee the passive income to total income of the corporation to ensure it does not surpass the 25 percent maximum for revenues earned from passive income over three successive years.