• Passive investment income – For S corps with accumulated earnings and profits( AE & P) from prior C corp years, having more than 25 % of gross receipts from passive investment income for three consecutive years.
• Improper trust elections – Failing to make timely elections for qualified Subchapter S trusts or electing small business trusts holding S corp stock.
• Change in corporate structure – Becoming an ineligible corporation, such as some underwriting insurance companies or banks.
Relief for inadvertent terminations: If an S corp’ s election is terminated due to an inadvertent error, the IRS may grant relief under IRC § 1362( f), allowing the corporation to retain its S corp status retroactively. To qualify, the corporation must:
• Have made a valid S election terminated inadvertently.
• Take corrective action within a reasonable period after discovering the issue.
• Make timely elections for trusts – Ensure any trusts holding S corp stock make the necessary elections promptly.
The S Corp Bottom Line
Maintaining S corp status requires oversight and adherence to IRS regulations. While the structure can provide significant tax advantages through pass-through taxation and potential tax planning opportunities, those benefits depend on continued compliance with shareholder, ownership and operational requirements. Understanding the rules and implementing best practices can help prevent inadvertent terminations and preserve the tax benefits associated with S corps.
Making the Right Choice
There is no one-size-fits-all answer when it comes to choosing between C corp and S corp status. Look to our tax pros to help explore each option so you can make an informed decision for your business
• Demonstrate the termination was not due to willful neglect.
• Agree to make any adjustments required by the IRS.
The corporation must submit a request detailing the circumstances and corrective measures taken. The IRS will evaluate the request and determine whether to grant relief.
Consequences of termination: If the S election is terminated and not remedied, the corporation becomes a C corp effective on the termination date. This change subjects the corporation to double taxation: Once at the corporate level and again at the shareholder level upon distribution of dividends. Additionally, the corporation generally cannot re-elect S corp status for five years without IRS consent.
About the Author
MIKE BAKER, CPA, CFP
PRINCIPAL, DOEREN MAYHEW ASSURANCE, PC PRINCIPAL, DOEREN MAYHEW ADVISORS, LLC mbaker @ doeren. com
With nearly 40 years of public accounting experience, Mike specializes in tax planning and consulting for closely held and middle market businesses. He helps clients navigate complex tax matters throughout the business lifecycle, from startup and growth to succession planning, ownership transitions and business sales.
Best practices to maintain S corp status:
• Monitor shareholder eligibility – Ensure all shareholders remain eligible and stock transfers comply with S corp requirements.
• Review agreements – Carefully draft and review shareholder agreements to prevent provisions that could create a second class of stock.
• Track income sources – Monitor the composition of income to avoid exceeding passive income limits, especially if the corporation has AE & P.
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