Inadvertent S Corp. Terminations

By Phillip Elefonte, CPA, MST, Holtz Rubenstein Reminick LLP, New York City

Editor: Alan Wong, CPA

S Corporations

Although limited liability companies are becoming the more popular choice of entity structure, S corporations are still a common entity choice. Therefore, it is important to stay current on the qualifications and ensure that the entity remains compliant. When an S election is made, requirements must be met to avoid an inadvertent termination of S status.

Terminations can be voluntary or involuntary; however, inadvertent involuntary terminations should be addressed immediately upon discovery. If the proper steps are taken, the IRS may grant a corporation relief and, subject to certain conditions, continue to treat the corporation as an S corporation.

S Corporation Requirements

S corporations are required under Sec. 1361(b) to meet the following criteria to qualify as a small business corporation:

  • Be a domestic corporation.
  • Have only allowable shareholders: individuals, certain trusts, and estates. Partnerships, corporations, or nonresident alien shareholders cannot be shareholders.
  • Have no more than 100 shareholders.
  • Have one class of stock.
  • Not be an ineligible corporation, i.e., certain financial institutions, insurance companies, and domestic international sales corporations.

Involuntary Terminating Events

An S corporation election may be terminated involuntarily if the entity ceases to qualify as a small business corporation or its passive income exceeds the passive income limitation. An S corporation ceases to qualify as an S corporation if it does not meet the criteria in Sec. 1361(b) discussed above. A termination for this reason can be considered to be inadvertent, as discussed below.

Passive income exceeds the passive investment income limitation if the S corporation has accumulated earnings and profits at the close of each of three consecutive tax years (this would occur only if the corporation or its predecessor had been a C corporation) and has gross receipts for each of those tax years, more than 25% of which are passive investment income (Sec. 1362(d)(3) and Regs. Sec. 1.1362-2(c)).

A corporation’s S election terminates effective on the date that the company commits the act that triggers the ineligibility. If a corporation elects to become an S corporation effective the beginning of its next tax year, and the corporation does not qualify as an S corporation on the first day of its next tax year, its election is treated as terminating that day. After a termination, the corporation is not eligible to elect S status for five years.

In the event of a termination, the corporation should attach to its return for the tax year in which the termination occurs a notification that a termination has occurred and the date of the termination (Regs. Sec. 1.1362-2(b)(1)).

Relief for Inadvertent Termination

If an S corporation does inadvertently terminate its S corporation status, the IRS may grant relief. The corporation must be able to demonstrate that the termination was inadvertent. The IRS may provide relief to corporations (via a waiver) and potentially restore S status retroactively, if the following are present:

  1. The corporation previously made a valid S election and that election terminated;
  2. The subchapter S election qualification loss was triggered by an inadvertent act;
  3. The IRS determines that the termination was inadvertent;
  4. Steps are taken within a reasonable period to correct the condition that rendered the corporation ineligible to be an S corporation; and
  5. The corporation and persons who were shareholders during the period of the termination agree to make any adjustments the IRS requires that are consistent with the treatment of the corporation as an S corporation (Regs. Sec. 1.1362-4(a)).

The IRS determines whether a termination or invalid election was inadvertent. The corporation has the burden of establishing that, under the relevant facts and circumstances, the IRS should determine that the termination or invalid election was inadvertent. The fact that the terminating event or invalidity of the election was not reasonably within the control of the corporation and, in the case of a termination, was not part of a plan to terminate the election, or the fact that the terminating event or circumstance took place without the corporation’s knowledge, notwithstanding its due diligence to safeguard itself against such an event or circumstance, tends to establish that the termination or invalidity of the election was inadvertent (Regs. Sec. 1.1362-4(b)).

Disproportionate Distributions

One of the most common errors S corporations make—making a disproportionate distribution—potentially can be viewed as creating a second class of stock and terminating S corporation status. The circumstances in which this error occurs are often very similar. Letter Ruling 200944018 illustrates a typical scenario involving a disproportionate distribution:

Facts: X is a corporation formed on day 1. X made an election to be treated as an S corporation on day 2. In year 1, X made disproportionate distributions to its shareholders by failing to make distributions to all of its shareholders. X discovered this in year 2 and made the necessary corrective distributions.

IRS ruling: The IRS stated that X’s S corporation election may have terminated because X may have had more than one class of stock. However, the IRS concluded that if X’s S election had been terminated, the termination was inadvertent within the meaning of Sec. 1362(f). The IRS also concluded that the corrective action taken by X and the shareholders for year 1 did not create a second class of stock under Sec. 1361. Consequently, the IRS ruled that X would be treated as continuing to be an S corporation from day 2 and thereafter, provided that X’s S election otherwise was not terminated under Sec. 1362(d).


As the number of letter rulings involving them indicates, inadvertent terminations of S corporation status occur relatively frequently. However, if a corporation’s termination is truly inadvertent and the corporation promptly corrects the cause of the termination after it is discovered, the IRS will grant the corporation relief from the termination.


Alan Wong is a senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York City.

For additional information about these items, contact Mr. Wong at 212-697-6900, ext. 986 or

Unless otherwise noted, contributors are members of or associated with DFK International/USA.

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