Ending an S Election

← Back to the Footnotes

This page is the sequel to the late election page. That one is about getting in; this one is about getting out, on purpose or by accident, and what the return looks like in the year it happens. It also covers the rule that governs every year a shareholder joins or leaves: the per-share, per-day allocation of §1377 and the two elections that close the books instead.

Step 1: Per-Share, Per-Day Allocation

§1377(a)(1): each item for the year is assigned equally to each day, and each day’s amount is assigned equally to the shares outstanding that day.

The arithmetic is share-days: shares × days owned, over total share-days for the year (shares outstanding × 365). The seller is treated as owning the stock on the day of sale (Reg. §1.1377-1(a)(2)(ii)); a decedent is the shareholder on the date of death; days with no shareholders are ignored.

Course example. 1,000 shares outstanding all year; $60,000 of ordinary income. Tom held 500 all year (182,500 share-days, 50.00%). Rick held 500 for 273 days and 200 for 92 days (136,500 + 18,400 = 154,900 share-days, 42.44%). Harry held 300 for 92 days (27,600, 7.56%). Income: Tom $30,000, Rick $25,464, Harry $4,536. Every separately stated item is divided the same way.

The consequence people do not expect: a shareholder who sold in March eats a pro rata share of December’s results. A big fourth-quarter loss or gain is partly his. That is what the elections in Step 2 are for.

↑ Back to top

Step 2: The Two Closing-of-the-Books Elections

• §1377(a)(2) — a shareholder’s entire interest terminates. The corporation may elect, with the consent of the departing shareholder and everyone who acquired shares from him (the “affected shareholders”), to treat the year as two separate years closing on the termination date, each allocated under normal accounting. Statement attached to the 1120-S for the year. Protects the seller from post-sale results and the buyer from pre-sale ones.
• Reg. §1.1368-1(g)(2) — a “qualifying disposition.” The same closing is available, by election of the corporation with all shareholders’ consent, when 20% or more of the outstanding stock is sold or redeemed within a 30-day period, or 25% or more new stock is issued, even though nobody’s entire interest ended.

A 49% shareholder cannot force either election, and cannot terminate the S election unilaterally — revocation takes more than 50%. Write the election into the buy-sell agreement so it is not a negotiation at closing.

↑ Back to top

Step 3: Voluntary Revocation

§1362(d)(1); Reg. §1.1362-6(a)(3). No form; a statement.

• Shareholders holding more than 50% of the shares (voting and nonvoting together) consent in writing.
• The corporation files a signed statement with the service center where Form 2553 was filed: that it revokes under §1362(a), the number of shares outstanding, the effective date wanted (if any), and the consents (name, address, TIN, shares held, date acquired; a community-property spouse signs too).
• Effective date. Filed by the 15th day of the third month of the year with no date specified: retroactive to the first day of that year. Filed later with no date: the first day of the next year. A specified date on or after the filing date: that date, which splits the year (Step 5). An election can even be revoked in its first year if the revocation is filed within the first 2 months and 15 days (Reg. §1.1362-2(a)).
• Rescission. A revocation may be withdrawn before its effective date, with the consent of everyone who consented to it plus anyone who became a shareholder since (Reg. §1.1362-6(a)(4)).

Why anyone does it: a buyer that cannot be an S shareholder (a corporation, a fund), a plan to go public, a decision that the 21% rate with reinvested earnings beats pass-through, or §1202 stock. Before the client signs, run the built-in gains arithmetic for the eventual return trip and read Step 7 for the AAA that is about to be trapped.

↑ Back to top

Step 4: Involuntary Termination Events

Reg. §1.1362-2(b). Each event has its own effective date, and the date matters because it fixes the split.

Event	Election ends
More than 100 shareholders	The day the limit is exceeded
Transfer of any share to an ineligible shareholder: a corporation, a partnership, a nonresident alien, a nonqualifying trust, an IRA	The day of the transfer, even for one share
A second class of stock issued (preferred; a disproportionate-distribution arrangement in the operating agreement)	That day
Becoming an ineligible corporation: a bank on the reserve method, an insurance company, a DISC	The day that business begins
Three consecutive years of C-corporation E&P plus passive investment income over 25% of gross receipts	The first day of the fourth year

Not a termination: a gift to children; issuing nonvoting common; a sale of less than 50% to another individual; a trust that holds the stock for two years after a death; an IRS recharacterization of excess salary as a distribution. For the inadvertent-termination fix (§1362(f), Rev. Proc. 2022-19) see Step 6 of the late election page; relief requires the corporation and all shareholders to agree to whatever adjustments the IRS requires and to correct the event within a reasonable time.

↑ Back to top

Step 5: The Split Year

§1362(e). The S short year ends the day before the terminating event; the C short year begins on that day.

• Default: pro rata by days (§1362(e)(2)). $60,000 of income; S year January 1 to September 1 (244 days), C year 121 days → $40,110 to the S short year, $19,890 to the C short year. Items go to the S side on the K-1s and to the C side on the Form 1120.
• Closing of the books is mandatory if 50% or more of the stock is sold or exchanged during the termination year (§1362(e)(6)(D)).
• Closing of the books is elective otherwise, by unanimous consent of everyone who was a shareholder at any time during the S short year plus everyone who held stock on the first day of the C short year (§1362(e)(3)). It cannot be mixed item by item.
• Both short-year returns are due on the C short year’s due date. The S short year counts as one year for carryover purposes but not toward the five-year wait. The C short year’s tax is annualized (§1362(e)(5)).

Study-question arithmetic: 180 C days / 365 × $74,000 = $36,493 to the C short year; 90 S days / 365 × a $50,000 loss = $12,329 to the S short year; a revocation specifying June 15 gives an S short year of January 1–June 14 and a C short year beginning June 15.

↑ Back to top

Step 6: Five Years, and the Exceptions

After a termination, no new election without IRS consent until the fifth tax year after the termination year (§1362(g)): terminated effective January 1, 2026 (or at any point in 2026) → earliest new election 2031. Reg. §1.1362-5(a) lets the IRS consent earlier where more than 50% of the stock is held by people who owned none on the termination date, or the termination was outside the control of the corporation and its substantial shareholders and not part of a plan. Both routes are by ruling request, with a user fee.

↑ Back to top

Step 7: The Post-Termination Transition Period

§1377(b). The former S corporation’s last chance to get the already-taxed income out without a dividend.

Three windows. (1) From the day after the last S year to the later of one year later or the due date, with extensions, of the last 1120-S. (2) 120 days after an audit determination that adjusts an S-period item. (3) 120 days after a determination that the election had terminated in an earlier year — the window that saves an inadvertent termination discovered late. A “determination” is a final court decision, a closing agreement, or a written agreement with the IRS (§1377(b)(2)).

What the window allows.

• Cash distributions come from AAA, tax-free to the extent of the shareholder’s stock basis (§1371(e)(1)). Excess over AAA is a dividend from the new C corporation’s current E&P. Cash only; property distributions do not qualify. Practice tip from the course: attach the final 1120-S Schedule M-2 to the first Form 1120 and label the distribution a §1371(e) distribution.
• Election out. With the consent of all distributees the corporation may treat distributions as dividends instead (Reg. §18.1371-1) — useful when the new C corporation faces accumulated-earnings or personal-holding-company exposure and wants E&P down.
• Suspended losses. A shareholder with §1366(d) losses suspended for lack of basis may deduct them to the extent he contributes capital — stock basis only; a new loan to the C corporation does not count — by the end of the period (§1366(d)(3)). To use $100,000 of suspended losses, contribute $100,000 to paid-in capital. Only shareholders still holding at the end of the window can use it.

The window does not reopen for a routine audit of open S years that merely changes AAA.

↑ Back to top

Reference: The Six-Step Distribution Order With E&P

§1368(c), for a corporation with C-year earnings and profits. The distributions page has the full treatment; this is the order.

1. AAA — tax-free, reduces basis, capital gain beyond basis.
2. PTI (pre-1983 previously taxed income) — tax-free, cash only, personal to the shareholder who was taxed on it.
3. E&P — a dividend, Form 1099-DIV, no effect on basis.
4. OAA — tax-free, reduces basis; cannot be moved by election.
5. Remaining stock basis — tax-free.
6. Capital gain.

Worked: AAA $8,000, E&P $30,000, basis $50,000, distribution $100,000 → $8,000 tax-free (basis to $42,000), $30,000 dividend (basis unchanged), $42,000 tax-free (basis to zero), $20,000 capital gain. E&P is never created in an S year; it is reduced by dividends, by redemptions and liquidations, and by investment credit recapture (§1371(c)). Elections (all distributees consent): E&P first; PTI first; E&P and PTI before AAA.

↑ Back to top

Questions at the desk

↑ Back to top ← Back to the Footnotes

Written for the Tax Shop desk from my continuing-education course notes; figures are for the 2026 tax year unless stated. Items marked (verify) are to be confirmed against primary sources before they are relied on. Private reference, not client advice.