Many business owners are not aware of elections 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 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.
Without one of the elections, an S corporation must allocate its profit/loss for the year pro rata to 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 considers the company’s profit/loss for the entire tax year.
The Section 1377(a)(2) election and Regs. Sec. 1.1368-1(g) election permit allocations of profit/loss differently from the “default” provision explained 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.
The Section 1377(a)(2) election is allowed for S corporations when a shareholder terminates 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.
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 redeem 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 affected 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. S corporation business owners 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 shareholders.