For all those doing business as an S corporation, there is some important information that’s good to know. It is always possible at some point during the life of an S corporation, the shareholders decide they either would prefer to operate as a C corporation or, because of some event, the S corporation’s status will be terminated. What are the consequences of such a change? Well, yes, the business now files a Form 1120 S but is there anything else you need to know?

Of course, the answer is yes!

First, let’s talk about the three ways in which an S corporation status is terminated:

• Voluntary revocation,
• No longer qualifies (for example, there is one too many shareholders), or
• For the last three years, passive income exceeds 25% of gross receipts and there are C corporation earnings and profits.

In most cases, an S corporation’s status terminates at some time during the year (rather than on the first day of the year), resulting in two short years: a short S corporation year and a short C corporation year. This creates the dilemma of how to calculate income and loss items for the year in which the change is made. There are two options:

• Perform a pro rata allocation, or
• Elect to close the books as of the date of termination.

Pro rata allocation: While generally the corporation has a choice between these two options, there are two instances when the business cannot use the allocation method but must instead close its books:

• If 50% or more of the corporation’s stock changes hands during the termination year, or
• An acquiring corporation makes a Section 338* election after the termination of the S status.

*When a corporation’s stock is acquired by another corporation that elects under IRS Code Section 338 to treat the acquisition as a qualified stock purchase.

If an allocation is allowed and is the selected option, all items of income, expense, loss, or credits are calculated for the entire year and then allocated to the two short years on a daily basis.

Close the books: In order to make the election to close the books as of the termination date (and, note that this is an election), all shareholders who held stock at any time during the S corporate year and anyone who is a shareholder on the first day of the C corporate year must unanimously consent to it. This is a Section 1362(e)(3) election and should be filed with the C corporation’s tax return.

Of course, inevitably there will be items (such as property taxes and insurance) which are assessed on an annual basis and, therefore, are subject to allocation on a pro rata basis.