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The revocation must be made by the corporation in the form of a statement. The statement must provide: revoking its election, shares of stock. day the revocation
(1) That the corporation is revoking its election to be treated as an S corporation under §1362(a),
(2) The number of shares of stock (including nonvoting stock) outstanding at the time the revocation is made, and
(3) The day the revocation is to be effective for revocations that specify a prospective revocation date. Someone authorized to sign the S corporation return should sign this statement. It should be delivered to the service center where the corporation filed its election to be an S corporation. To this statement of revocation, the corporation should attach a statement of consent, signed by each shareholder who consents to the revocation. It should also provide the number of shares of outstanding stock (including nonvoting stock) each shareholder holds at the time the revocation is made.
The revocation is effective:
(1) On the first day of the tax year if the revocation is made by the 15th day of the 3rd month of the same tax year;
(2) On the first day of the following tax year if the revocation is made after the 15th day of the 3rd month of a tax year; or
(3) On the date specified if the revocation specifies a date on or after the day the revocation is made (§1362(d)(1)).
A corporation that specifies a prospective date for revocation that is other than the first day of the tax year will create an S termination year.
Ceasing to Qualify
Certain events can cause the corporation to cease qualifying as an S corporation.
Some of these include:
(1) Having more than 100 shareholders,
(2) Transferring stock in the S corporation to
(a) A corporation,
(b) A partnership,
(c) An ineligible trust, or
(d) A nonresident alien,
(3) Creating a second class of stock, and
(4) Acquiring a subsidiary, other than certain nonoperating subsidiaries.
Termination of S corporation status will be effective as of the date the terminating event occurred. A corporation that ceases to be a small business corporation on a date other than the first day of the tax year will create an S termination year.
Passive Income – §1362
The election is also terminated if the S corporation fails the “passive income test.” The passive income test is quite narrowly stated. To fail this test, the corporation must have both:
(1) Earnings and profits from prior years when it was a C corporation, and
(2) Excessive passive income.
Passive income consists of gross receipts from royalties, rents, dividends, interest, annuities, or sales of stock or securities. To flunk the test, the gross receipts of an S corporation must consist of at least 25% passive income for each of three consecutive taxable years (§1362(d)(3)). The election is terminated at the beginning of the 4th year. Even though a corporation has more than 25% passive income for three years, its election will not be terminated if the corporation elected subchapter S status
when it was first formed (it would not have any pre-subchapter S earnings and profits).
Termination of S corporation status because of a violation of the passive income restriction will be effective on the first day of the tax year that follows the third consecutive tax year referred to above. See also Inadvertent Termination, discussed later.
S Termination Year
Any term that is effective during the tax year on a date other than the first day of that tax year will create an S termination year. The part of the S termination year ending on the date before the effective date of the termination is the 1120S (S corporation) short tax year. The part of the S termination year beginning on the first day on which the termination is effective is an 1120 (C corporation) short tax year. After the S termination year is divided into a 1120S short year and 1120 short year, the separately stated items of income, loss, credit, and deduction, and the amount of the non-separately stated income or loss must be divided between the periods. There are two methods that can be used to make this division. They are:
(1) A pro-rata allocation, or
(2) An allocation based on normal tax accounting rules.
After the separately stated items and the non-separately stated income or loss are divided, (Quoted) one set of amounts is used for the 1120S short year, and the other set of amounts is used for the 1120 short year. The corporation will have to file two returns to cover the S termination year. One covers the 1120S short year, and one covers the 1120 short year. The S termination year will count only as one tax year for figuring carry-backs and carryovers, even though two returns are filed for the year¨.
A pro rata allocation must be used unless the shareholders and S corporation specifically indicate they choose to use the other allocation method. The pro-rata allocation is made in the following way:
(1) Determine for the entire S termination year the amount of each separately stated item of income, loss, deduction, or credit, and the amount of the non-separately stated income or loss;
(2) Divide each amount by the number of days in the S termination year;
(3) Multiply the amounts from step (2) by the number of days in the Form 1120S short year; and
Note: These amounts are used for the Form 1120S filed for the 1120S short year.
(4) Multiply the amounts from step (2) by the number of days in the 1120 short year.
Note: These amounts are used for the Form 1120 filed for the 1120 short year. The pro rata allocation may not be made if 50% or more of the corporation’s stock is sold or exchanged during the S termination year.
Allocation Based On Normal Accounting Rules
If a company decides to do things differently, it can use another allocation method based on regular accounting rules. However, to make this decision, all current and former shareholders must agree during the 1120S short year and on the first day of the 1120 short year. The company can confirm this decision by filing a statement with the return for the 1120 short year. The alternate method reports all income, loss, deduction, or credit based on the company’s books and records, including worksheets. That means that you need to split items between the 1120S short year and the 1120 short year based on when they were realized or incurred according to the company’s records. The company must use the alternate allocation method if 50% or more of its stock is sold or exchanged during the S termination year.
Annualization of 1120 Short Year
To figure the tax on Form 1120 for the 1120 short year, the taxable income for the 1120 short year must be annualized. This annualization is done in the following way:
(1) Multiply the taxable income of the 1120 short year by the number of days in the S termination year;
(2) Divide the amount from step (1) by the number of days in the 1120 short year;
(3) Figure the tax on the amount from step (2); 9-24(4) Multiply the tax from step (3) by the number of days in the 1120 short year; and
(5) Divide the amount from step (4) by the number of days in the S termination year To figure the corporate alternative minimum tax for the short year, make the following adjustments:
(1) The alternative minimum taxable income for a short period is placed on an annual basis by multiplying that amount by 12 and dividing the result by the number of months in the short period, and
(2) The tentative minimum tax for the tax year will have the same relation to the tax figured on an annual basis as the number of months in the short period has to 12. 9-26
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