Inadvertent S Corporation Status Terminations: Revocations, Remedies, and Recent Cases

S corporations continue to be the entity of choice, with far more Forms 1120-S filed annually than Form 1065 for partnerships. However, many businesses are surprised to learn that they are, in fact, not S corporations. Losing Subchapter S status can subject a company to double taxation as a C corporation. Although sometimes intentional, most often, loss of S status is unexpected and due to a misstep. 

IRC Section 1361(b) defines an S corporation as one that does not:

(a) have more than 100 shareholders

(b) have a shareholder, other than certain estates or trusts, who is not an individual

(c) have a nonresident alien as a shareholder

(d) have more than 1 class of stock

Unintentionally, a corporation may violate one of the requirements. 

Even companies that meet the initial requirements can inadvertently lose their S status when changes occur, such as the addition of ineligible shareholders or the creation of a second-class stock. 

Shareholders and tax professionals are aware that S corporation distributions should be made in proportion to ownership. Historically, practitioners have identified and recommended steps to rectify disproportionate distributions. Recent case law emphasizes the importance of provisions in an S corporation's governing documents in determining whether disproportionate distributions create a second class of stock. Tax advisers working with flow-through entities need to be familiar with frequent situations that can jeopardize this valuable status and recent legislation surrounding these terminations.

Listen as our panel of S corporation specialists reviews actions that may compromise an S election, intentional revocations, and remedying inadvertent termination of S corporation status.