Terminating S Corporation Status In Connection With A Financing

One issue that is worth paying attention to in financing transactions in which an S corporation’s S corporation status will terminate is how losses in the year in which the investment is made will be allocated.

Investors might think that upon their investment and termination of the S corporation status, the losses funded with their dollars in the year of investment will generate a net operating loss in that year, and that those losses will be available to offset taxable income in future years. This is not necessarily true because of the way in which the losses allocated to the short S corporation tax year and short C corporation tax year will be calculated. If the investors acquire a minority stake, and if the S corporation status terminates on a date other than the first day of the corporation’s taxable year, the corporation’s taxable year will be bifurcated into a short S year and a short C year, and it will be necessary to allocate the income and loss recognized by the corporation in the S termination year between these two short tax years.

Default; Pro Rata Allocation Method

The default method applied to allocate the income or loss recognized by a corporation in an S termination year is the pro rata allocation method. Under this method, first the income or loss for the entire year is determined (for both the short S corporation part of the year and the short C corporation part of the year) and then an equal portion of such amount is assigned to each day of the S termination year (to both the S and C corporation short years). Because this default allocation method disregards the actual time at which items of income or loss are recognized, it can have unexpected results.

For example, suppose an institutional investor or other non-eligible S corporation shareholder invests $2M in an S corporation startup (with two existing shareholders who are both individuals, A and B) on July 1, and it is expected that the $2M will be substantially utilized before the end of the calendar year to fund operations of the startup.  On the investment the startup’s S corporation status will terminate because S corporations cannot generally have non-individual shareholders.  Assuming the startup uses a calendar year, the corporation’s taxable year will be bifurcated into a short S year (running form January 1 though June 30) and a short C year (running from July 1 through December 31).

You might think that the $2M expended from July 1 to December 31 would be allocated to the short C year in which it was realized, generating a net operating loss of approximately $2M–assuming the startup has no revenue.  However, under the default allocation method, half of the $2M loss is allocated to the short S year and passed through to A and B who may not be able to fully utilize this loss due to the limitations on the deductible of loss that apply to individuals.

Election To Have Items Assigned To Each Short Taxable Year Under Normal Tax Accounting Rules

The startup can elect out of the default allocation method – and follow a “closing of the books” method (which the Internal Revenue Code refers to as “Normal Accounting Rules”) which allows the startup to close its books on the date its status as an S corporation terminates – but only if all shareholders consent.  In the above example, if all of the shareholders consent to a closing of the books election, the $2M net operating loss generated by the corporation in the C short year would be allocated to the C short year and carried forward to future table years and used to offset taxable income recognized in those future taxable years.

About Joe Wallin

Joe Wallin focuses on emerging, high growth, and startup companies. Joe frequently represents companies in angel and venture financings, mergers and acquisitions, and other significant business transactions. Joe also represents investors in U.S. businesses, and provides general counsel services for companies from startup to post-public.
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