S Corp Election, Revocation, and Termination Under § 1362

S corporation status under subchapter S is elective under § 1362(a) and can be lost in three ways: voluntary revocation under § 1362(d)(1), failure of the small business corporation requirements under § 1361(b), or termination under the passive investment income rule of § 1362(d)(3).

Eligibility — § 1361(b)

To be a small business corporation, the entity must be a domestic corporation (or LLC electing corporate treatment under § 7701) that is not an ineligible corporation, with no more than 100 shareholders, only eligible shareholders (individuals; estates; certain trusts including QSSTs, ESBTs, and grantor trusts; certain tax-exempt organizations), and only one class of stock.

The one-class-of-stock rule under § 1.1361-1(l) looks at outstanding shares and their rights to distribution and liquidation proceeds. Differences in voting rights are explicitly permitted. The most common practitioner traps: disproportionate distributions, non-pro-rata loans with equity-like terms, and operating agreement provisions that create distinctions in distribution rights.

Election mechanics

Form 2553 must be signed by all shareholders on the day of the election (and any spouses with community property interest). The election is effective for the entire taxable year if filed during the 2-month-15-day window of § 1362(b)(1). Filings after the window are effective the following taxable year unless late-election relief applies.

Rev. Proc. 2013-30 provides automatic late-election relief if: (i) the entity intended to be an S corp from the requested effective date; (ii) the entity failed only because Form 2553 was not timely filed; (iii) the entity has reasonable cause; and (iv) Form 2553 is filed within 3 years and 75 days of the requested effective date. The relief is requested by attaching the late Form 2553 to the corporation’s timely-filed Form 1120-S with the required statement.

Voluntary revocation — § 1362(d)(1)

Revocation requires consent of shareholders holding more than 50% of outstanding stock on the day of the revocation. Filed by the 15th day of the 3rd month of the taxable year, the revocation is effective for that year. Filed after, it’s effective the following year. A prospective effective date may be specified.

Post-revocation, the corporation is C-corp (if a state-law corporation) or reverts to its prior tax classification under check-the-box. The 5-year reelection rule of § 1362(g) applies; reelection within 5 years requires IRS consent under Rev. Proc. 2003-43.

Automatic termination — § 1362(d)(2)

Termination is automatic and effective the day the corporation ceases to be a small business corporation. Common triggers: stock transfer to an ineligible shareholder (e.g., to an LLC, a non-grantor non-qualifying trust, an NRA), exceeding the 100-shareholder limit, creation of a second class of stock, or failure to meet the domestic-corporation requirement.

The day of the disqualifying event ends the S short year; a C short year begins the next day. Pro rata allocation of items between the short years is generally required under § 1362(e)(2) unless all shareholders elect the “closing of the books” method under § 1362(e)(3).

Passive investment income termination — § 1362(d)(3)

Only applies to S corps with accumulated earnings and profits (E&P) carried over from a prior C years. If passive investment income exceeds 25% of gross receipts for 3 consecutive years, the election terminates effective the first day of the 4th year. § 1375 excess net passive income tax may also apply in any year of the disqualifying period.

Inadvertent termination relief — § 1362(f)

If the IRS determines that the termination was inadvertent, the corporation and shareholders correct the condition causing the termination, and the corporation and shareholders agree to be treated as required by the IRS, the election is treated as continuing in effect. This is a PLR ruling under Rev. Proc. 2024-1 (annually-reissued). Filing fees apply. Inadvertent-termination relief is the most common S-corp PLR by volume and is generally granted on a routine basis when the inadvertence is supported.

Practical notes

1. Document acceptance. Retain CP261 in the corporation’s permanent file. Many practitioner errors trace to assuming the election was accepted absent confirmation.
2. Stock transfer protocols. Shareholder agreements should require pre-clearance of all transfers to confirm transferee eligibility.
3. Distribution discipline. All distributions must be pro rata to outstanding stock; cumulative non-pro-rata risks a second-class-of-stock argument.
4. QSST and ESBT elections. If shares are held in trust, confirm the QSST election under § 1361(d)(2) or the ESBT election under § 1361(e)(3) is in place and current.
5. Reasonable cause file. Prepare a contemporaneous reasonable-cause statement on any late or amended election; saves time at IRS correspondence.