Most business owners are aware of the election that has to be made to be taxed as an S corporation with the filing of Form 2553 with the Internal Revenue Service. Many business owners may not be aware of other elections that are available to existing S corporations with significant ownership changes occurring in a given tax year, specifically the Internal Revenue Code Section 1377(a)(2) election and the Treasury Regs. Sec. 1.1368-1(g) election. These elections are important considerations for shareholders of S corporations undergoing significant ownership changes and should be addressed with the company’s CPA early in the ownership change process.
First, it is important to note that without these elections, an S corporation must allocate its profit/loss for the year pro rata to its shareholders based on the number of outstanding shares each shareholder owns during the tax year. Items of income and expense for the entire year are divided by 365 days to calculate the per day amount. The per share amount is calculated based on each shareholders’ ownership on each day of the year. Even though a shareholder may terminate their complete interest in the S corporation early during a given tax year, the allocation of profit/loss takes into account the company’s profit/loss for the entire tax year.
The Section 1377(a)(2) election and the Regs. Sec. 1.1368-1(g) election are elections to allocate profit/loss differently from the “default” provision indicated above for a tax year during which an S corporation undergoes a significant ownership change. These elections allow the S corporation to treat the taxable year as if it consists of two separate taxable years, one ending on the date of the significant ownership change, and one starting on the day after the significant ownership change. By doing so, the profit/loss allocation is not for the entire tax year, but rather there are two separate allocations with one for the period up to and including the date of the significant ownership change and one for the remaining portion of the company’s tax year. With the election made, profit/loss is only allocated to shareholders owning shares during each of the two separate taxable years.
The Section 1377(a)(2) election is allowed for S corporations with a shareholder terminating their complete interest in the company. The termination of a shareholder’s complete interest may arise in the event of a share redemption upon retirement, a sale of all a shareholder’s shares, a gift of all a shareholder’s shares, or a shareholder’s death. The key trigger for a Section 1377(a)(2) election is a shareholder’s complete termination of their interest in the company.
The Regs. Sec. 1.1368-1(g) election is allowed under any of the following scenarios: (i) a shareholder disposes of 20% or more of the company’s outstanding shares; (ii) a shareholder redeems 20% or more of the company’s outstanding shares; (iii) there is an issuance of an amount of stock equal to or greater than 25% of the previously outstanding stock to one or more new shareholders during any 30-day period during the company’s tax year. This election has broader application as a shareholder does not have to dispose or have redeemed their entire interest in the company (only a minimum of 20%) and it addresses the issuance of new shares to new shareholders (at least 25% of the previously outstanding stock).
Why are these elections important? The decision to make an election can have a dramatic impact on all of the shareholders’ (departing, remaining, and new) tax liability depending on the circumstances. This can especially be the case with a company whose profits/losses are not equally earned throughout a given tax year. Business owners in an S corporation that are anticipating significant ownership changes in a coming tax year should meet early with their company CPA to determine the implications of an election being made so a decision can be agreed upon by all of the shareholders.
If you have questions concerning these elections, or need a referral to a CPA to assist with evaluating the tax consequences of these elections, please contact our firm, Connors Morgan, PLLC, and one of our attorneys will be happy to assist you.