Can you accidentally terminate the S Corporation status?
Yes, you can. You can unintentionally or inadvertently terminate the S election by doing something that an S corporation is prohibited from doing.
How Inadvertent Termination Occurs
For example, I've mentioned elsewhere at this web site that basically only individuals who are U.S. citizens or permanent residents can own shares in an S corporation.
If an S Corporation or S corporation shareholder sells shares to a partnership or C corporation, that new ineligible shareholder may terminate eligiblity to operate under an S election. Similarly, if a permanent resident shareholder loses his or her green card, that can terminate eligibility to operate under an S election.
Another common way this termination of previous eligbility might happen is when the S corporation doesn't treat its shareholders "evenly" when making distributions.
An S corporation can have only one class of stock. What this means, in practice, is that shareholders need to receive the correct proportional share of distributions that are paid. Each share of S corporation stock, for example, needs to receive the exact same per-share distribution amount. You can't preferentially treat one of the shareholders (the majority shareholder, for example.) That preferential treatment creates a second class of stock. and then that second class of stock terminates the entity's eligibility to use the Subchapter S status.
Remedying Accidental Subchapter S Termination
If an S corporation inadvertently goofs up its S status eligibility, prompt correction of the ineligibility and (if necessary) a little pleading with the IRS will often fix the problem.
Second, if an S corporation has multiple shareholders, the S Corporation should have a shareholder agreement that prohibits shareholders from doing things that terminate the Subchapter S status. That shareholders agreement may provide guidance as to how an accidental termination should be handled--and it may also provide for innocent shareholders to gain some relief.
Intentional Subchapter S Status Termination
A final related point: People commonly ask about intentional conversions from S corp to a C corp status, but going from an S corporation to a C corporation is probably something you should do only after consulting with a knowledgeable tax practitioner. You typically would not want to make an S to C corporation change or conversion unless you were forced to. I do talk about converting from S corporation to C corporation status in another question-and-answer discussion (see here.)
Additional Information You May Find Useful
If you want additional information about how to maximize the tax savings related to running a business or investment venture, you may also be interested in one of our downloadable e-books (see descriptions below). Each book covers a category of tax planning topics that easily save a business owner significant amounts of income or self-employment taxes (potentially thousands of dollars a year) and is instantly downloadable.
One of the most powerful tactics for saving small business taxes is maximizing your deductions. You can literally save thousands in taxes each year.Read More
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