Section 1377(a)(2) Election for S Corporations

A Section 1377(a)(2) election lets an S corporation close its books on the day a shareholder fully exits, splitting the tax year into two short periods so income, losses, deductions, and credits are allocated based on who actually owned stock when those items arose. Without the election, the corporation must spread the year’s results evenly across every calendar day and allocate each day’s slice by ownership on that date. That default routinely misfires: a shareholder who left in March can still be taxed on profits earned in December, and a buyer who arrived in July can be handed losses that piled up before they showed up. The election exists to fix that mismatch.

Make it whenever the timing of the corporation’s earnings during the year is uneven enough that the daily pro rata method would produce a materially wrong allocation between the departing and remaining shareholders. If earnings are roughly ratable across the year, the default rule and the election produce similar numbers and the paperwork isn’t worth it.

The Default Daily Pro Rata Rule

Under Section 1377(a)(1), the corporation takes each item on its return, divides the annual total by the number of days in the tax year, multiplies by each shareholder’s ownership percentage on each day, and sums the results.¹ The math is mechanical and ignores when the money was actually earned or spent. That is the whole problem the election addresses.

The distortion runs both directions. A departing shareholder can be allocated post-exit profits; a new or remaining shareholder can absorb pre-arrival losses. Those misallocations then flow into stock basis, into the gain or loss reported on the sale, and into every affected shareholder’s tax bill.

When the Election Is Available

Section 1377(a)(2) applies only when a shareholder’s entire interest in the corporation ends during the tax year. A sale of all shares, a full redemption by the corporation, a gift of the entire stake, and the death of a shareholder all qualify.¹ Reducing a stake without leaving does not. A shareholder who cuts ownership from 40 percent to 10 percent cannot trigger the election, no matter how large the transfer.

The termination date is the last day the departing person is treated as a shareholder. For a stock sale, that is usually the closing date. For a redemption, it is the date the shareholder surrenders the shares. That date becomes the dividing line between the two short periods.

Redemptions carry an extra hurdle. A redemption must first qualify as a sale or exchange under Section 302, and Section 302 applies the constructive ownership rules of Section 318, which attribute stock owned by family members to the redeeming shareholder.² If attribution treats the shareholder as still owning stock through a spouse or child, the redemption may not be a complete termination and the election is unavailable.

Who Must Consent

The corporation and every “affected shareholder” must consent. The regulatory definition is narrower than many people expect. In a sale to another individual, affected shareholders are just the departing shareholder and anyone who received shares from that departing shareholder during the tax year.³ Often that means the seller, the buyer, and the corporation.

The group is much larger when the exit is a redemption. If the departing shareholder transferred shares back to the corporation instead of to a specific buyer, then every person who was a shareholder at any point during the tax year is an affected shareholder and must consent.³ Deals structured as redemptions should address that consent requirement in the shareholder documents before closing.

How to Make the Election

The corporation makes the election by attaching a statement to its Form 1120-S for the year the termination occurred. The statement can go on a timely filed original return or on an amended return.⁴ One statement covers all terminating elections made during the same tax year.

The statement must include four items:³

A declaration that the corporation elects under Section 1377(a)(2) to treat the tax year as two separate short years.
The details of the termination: when it occurred and how (sale, gift, redemption, death).
The signature of an authorized corporate officer, under penalties of perjury.
Confirmation that the corporation and each affected shareholder consent.

The corporation must also write “Section 1377(a)(2) Election Made” at the top of each affected shareholder’s Schedule K-1.⁴ The actual signed consent forms stay in the corporate records. The IRS lets the corporation represent that consents are on file rather than attaching them, but an examiner will want to see the originals.

Deadline and Late Filing

The deadline is the due date of the Form 1120-S for the year of termination, including extensions. For a calendar-year S corporation, that is March 15 of the following year, or September 15 with an extension. Because the regulations permit the election on an amended return, a corporation that missed the original filing can still make the election by amending.³ If both the original and amended-return windows have closed, the default daily pro rata allocation applies and there is no established automatic relief procedure specific to this election.

How the Two Short Periods Work

Once the election is in place, the corporation closes its books as of the termination date and computes income, losses, deductions, and credits for each short period using its normal accounting method. The first period runs from the beginning of the tax year through the termination date. The second runs from the day after termination through year-end.¹

Items from the first period are allocated only among shareholders who held stock during that period, including the departing shareholder. Items from the second period go only to shareholders who held stock after the termination date. The departing shareholder’s final K-1 reflects only what happened up to their exit. Nothing after that shows up on their return.

The corporation still files one Form 1120-S for the full year. The two-period split is an internal allocation mechanism, not a change in filing obligations.

Effect on Basis, Gain or Loss, and Distributions

The election’s practical payoff shows up in stock basis. The departing shareholder adjusts basis using only the income and losses from the first short period, and that adjusted basis then drives the capital gain or loss on the stock sale. Under the default rule, basis would move by a slice of the full year’s results, which can inflate or deflate the reported gain depending on when the corporation actually made its money.

The Accumulated Adjustments Account also splits at the termination date. The AAA tracks previously taxed but undistributed S corporation earnings and determines whether distributions come out tax-free or are treated as taxable dividends when the corporation carries earnings and profits from a prior C corporation period.⁵ Distributions during the first short period are treated as occurring before distributions in the second.

If the first period produced strong income, the AAA balance will usually cover distributions made in that period and keep them tax-free. If the first period produced a loss, the shrunken AAA can push distributions into dividend treatment to the extent of accumulated earnings and profits, or into capital gain beyond that. For the remaining shareholders, the second-period allocation captures their economic stake going forward without inheriting a share of pre-termination results.

Partial Dispositions Fall Under a Different Rule

If a shareholder cuts back their stake without leaving, Section 1377(a)(2) is off the table, but a separate election under Treasury Regulation 1.1368-1(g) may apply. That regulation covers “qualifying dispositions,” which include a sale or redemption of 20 percent or more of the corporation’s outstanding stock within any 30-day window, or the issuance of new stock equal to 25 percent or more of previously outstanding shares within a 30-day period.⁶

The two elections are mutually exclusive for the same transaction. When an event qualifies as a complete termination, you use Section 1377(a)(2) and the 1.1368-1(g) election is unavailable.⁶ Identifying which election fits the transaction is the first step in getting the allocation right.

1
Office of the Law Revision Counsel. 26 USC 1377 – Definitions and Special Rule
2
Office of the Law Revision Counsel. 26 USC 318 – Constructive Ownership of Stock
3
Internal Revenue Service, Treasury. 26 CFR 1.1377-1 – Pro Rata Share
4
Internal Revenue Service. Instructions for Form 1120-S
5
eCFR. 26 CFR 1.1368-2 – Accumulated Adjustments Account (AAA)
6
Internal Revenue Service, Treasury. 26 CFR 1.1368-1 – Distributions by S Corporations