Terminating an S election by revocation

Circumstances may arise where more favorable results are achieved by not operating as an S corporation. For example, for tax years beginning after Dec. 31, 2017, the corporate tax rate is a flat 21%, with a blended rate (Sec. 15) applicable to fiscal-year corporations with year ends after that date. Additionally, the corporate alternative minimum tax is repealed for tax years beginning after Dec. 31, 2017. Because of these changes, shareholders may want to revoke an S election. Furthermore, the shareholders may want to revoke the S election to take advantage of the more favorable fringe benefit rules or fiscal-tax-year rules available to C corporations. Finally, shareholders may find it impossible to continue meeting the S corporation eligibility rules because of a desire, for example, to admit an ineligible shareholder (such as a corporation or a nonresident alien individual) or to issue preferred stock with differing rights to distribution or liquidation proceeds.

Revoking the S election

To voluntarily terminate its S status, a corporation may file a revocation for any of its tax years, including the first tax year for which the election is effective (Sec. 1362(d)(1)(A)).

The revocation is made by a corporation in the form of a statement filed with the IRS Service Center where the corporation properly filed its S election, Form 2553, Election by a Small Business Corporation. The statement should be signed by a person authorized to sign Form 1120S, U.S. Income Tax Return for an S Corporation, (i.e., a corporate officer) and must provide (Regs. Sec. 1.1362-6(a)(3)):

• That the corporation is revoking its election under Sec. 1362(a) to be taxed as an S corporation;
• The number of shares of stock, including nonvoting stock, outstanding at the time the revocation is made; and
• The effective date of the revocation, if it is to be a prospective revocation (see below).

Law change alert: The law known as the Tax Cuts and Jobs Act (TCJA), P.L. 115-97, allows S corporations converting to C corporations by a revocation to amortize any positive Sec. 481(a) adjustment over a six-tax-year period if required to make an accounting method change to conform to C corporation rules as a result of the revocation. For example, if the entity that converted into a C corporation is required to use the accrual method of accounting, the calculated Sec. 481(a) adjustment can be taken into account over six tax years. To get this benefit, the corporation must have been an S corporation on Dec. 21, 2017, and must retain the same shareholders in the same proportion during the two-year period beginning Dec. 22, 2017. Note that the extended amortization period applies only to revocations of the S election and not to inadvertent terminations. Also, a change to the accrual method of accounting may not be necessary because the TCJA expands the rules that allow C corporations to use the cash method.

Obtaining shareholder consents to the revocation

A separate statement of shareholder consent should be attached to the statement of revocation and be signed by each shareholder who consents to the revocation. This statement will provide evidence that shareholders owning more than 50% of the outstanding stock at the time the revocation is filed consented to the revocation. All S shareholders, voting and nonvoting, must be considered in the 50% determination (Sec. 1362(d)(1)(B); Regs. Sec. 1.1362-2(a)(1)).

Family members: Family members are treated as one shareholder for purposes of the 100-shareholder limit. For all other purposes, including consents, each person holding an interest in the S corporation’s stock is considered a shareholder. Thus, shareholders owning more than 50% of the corporation’s outstanding stock at the time the revocation is filed must consent to the revocation, without regard to how those shareholders are counted for purposes of the 100-shareholder limit.

Filing the revocation when an LLC revokes S status

An LLC can elect to be treated as an S corporation. Under Regs. Sec. 301.7701-3(c)(1)(v)(C), an LLC is treated as having made an entity classification election to be a C corporation, followed by an election to be an S corporation. If its S election is revoked, the entity reverts to being a C corporation for all tax purposes, unless it is eligible for and makes a subsequent entity election to be taxed as a partnership or a single-member LLC. The LLC revokes the election the same way a corporation would. LLC members owning more than 50% of the LLC must consent to the revocation, and the revocation should be signed by an LLC member authorized to sign the Form 1120S.

Determining the revocation’s effective date

Revocation statement that does not specify an effective date: If a revocation does not specify an effective date, it is effective retroactive to the beginning of the tax year if made on or before the 15th day of the third month of the tax year. If made after that date, it is effective as of the beginning of the following year (Sec. 1362(d)(1)(C); Regs. Sec. 1.1362-2(a)(2)(i)).

Prospective revocation:A revocation may specify a prospective effective date (Sec. 1362(d)(1)(D); Regs. Sec. 1.1362-2(a)(2)(ii)). This can be any date on or after the day on which the revocation is filed, but it must be stated in terms of a specific day, month, and year, and not in terms of a specific event. Revocations that designate an effective date during a tax year will split the “S termination year” into short Subchapter S and Subchapter C tax years.

The specified revocation date must be on or after the date the required revocation statements are filed; otherwise, the effective date will be considered the first day of the tax year, if the revocation statement is filed before or on the 15th day of the third month of the tax year, or, if the statement is filed after that date, the first day of the following tax year (Sec. 1362(d)(1)(D); Regs. Sec. 1.1362-2(a)(2); in IRS Letter Ruling 8938008, a notice mailed on Nov. 3 with a specified effective date of Oct. 27 was effective the first day of the following tax year).

To ensure that the revocation occurs when planned, the authors strongly recommend that the effective date be specified on the revocation statement.

Filing date: The filing date is generally the date the revocation is mailed, as determined by the date of the U.S. postmark. The authors recommend that the revocation statement be sent by certified mail, return receipt requested, to establish that it was timely filed.

The following examples illustrate when revocation statements filed on various dates become effective.

Example 1. Specifying a retroactive or prospective revocation date: A calendar-year S corporation files a revocation on March 10, 2018. If no effective date is specified, or an effective date before March 10 is specified in the revocation statement, the revocation is effective on Jan. 1, 2018. If the revocation statement specifies that the revocation is effective on any date on or after March 10, it will be effective on that date.

Example 2. Specifying a prospective revocation date: A calendar-year S corporation files a revocation on March 24, 2018. It can specify March 24 or any date afterwards as the effective date of the revocation. It cannot revoke its election retroactively by specifying an effective date before March 24.

Example 3. Determining the revocation date when no date is specified: A calendar-year S corporation files a revocation (that does not specify an effective date) on March 10, 2018. The revocation is retroactively effective as of Jan. 1, 2018. If the corporation had filed the revocation (that did not specify an effective date) on March 24, 2018, the revocation would be prospectively effective as of Jan. 1, 2019.

S status continues unless revocation is timely filed

A properly completed revocation of an S election can become effective on any specified date on or after the day on which the revocation is filed. If the revocation is filed on or before the 15th day of the third month of the tax year, it can be effective retroactively to the beginning of the tax year (Sec. 1362(d)(1)(C); Regs. Sec. 1.1362-2(a)(2)(i)). In an IRS information letter (INFO 2010-0249), the IRS addressed a situation where an S corporation had completed and filed Form 2553 to become an S corporation but, thereafter, filed Form 1120, U.S. Corporation Income Tax Return, as if the S election had not been made.

The IRS concluded that no revocation had taken place. Rather, the corporation had been an S corporation continuously from the S election’s effective date until the present time. By filing Form 2553, the corporation made an election to be treated as an S corporation, and that status remains in effect until properly revoked or otherwise terminated. An S election for a prior tax year cannot be revoked because no provision within the Code allows late revocations of S corporation elections. The IRS also reminded the corporation that if it wanted to revoke its S election for the current year, the revocation had to be filed by the 15th day of the third month after the beginning of the tax year.

This case study has been adapted from PPC’s Tax Planning Guide: S Corporations, 32d edition (March 2018), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters, Carrollton, Texas, 2018 (800-431-9025; tax.thomsonreuters.com).