Which of the Following Terminates a Subchapter S Election?

Three things terminate a Subchapter S election: a voluntary revocation approved by shareholders holding more than half of the outstanding shares, the corporation’s failure to meet any eligibility requirement in Internal Revenue Code Section 1361, or three consecutive years of excessive passive investment income while the corporation still carries accumulated earnings and profits from prior C corporation years. The first is deliberate. The other two often happen without anyone noticing until the IRS points it out.

Voluntary Revocation

Shareholders can end the election by choice. The corporation files a written statement of revocation with the IRS service center where it files its annual return, and that statement must clearly say the corporation is revoking its S election.¹ There is no dedicated IRS form. The revocation is valid only if shareholders holding more than half of all outstanding shares consent, and both voting and non-voting shares count toward that threshold.²

Timing controls the effective date. File on or before the 15th day of the third month of the tax year and the termination can be retroactive to the first day of that year. For a calendar-year corporation, that deadline is March 15. File after that date and the revocation takes effect on the first day of the next tax year, unless the statement specifies a later prospective date.¹

Losing Eligibility Under Section 1361

An S corporation must continuously satisfy every eligibility requirement in Section 1361. The moment it fails any one of them, the election terminates automatically on the date of the disqualifying event.² These terminations are involuntary, and most accidental terminations trace back to one of the following events.

Going Over 100 Shareholders

An S corporation cannot have more than 100 shareholders. All members of a family are treated as a single shareholder, with “family” defined as a common ancestor, all lineal descendants of that ancestor, and spouses or former spouses of any of them, going back up to six generations from the youngest generation of shareholders.³ Spouses filing jointly also count as one. Cross the cap and the election ends.

Stock Transferred to an Ineligible Shareholder

Only certain owners may hold S corporation stock: U.S. citizen and resident individuals, certain trusts, and estates. Partnerships, other corporations, and nonresident aliens are prohibited.⁴ A single share transferred to any prohibited shareholder terminates the election on the date of transfer.

This is where quiet terminations happen. A shareholder dies and the stock passes through the estate into an ineligible trust. A shareholder moves abroad and gives up U.S. residency. A divorce settlement transfers shares to a nonresident alien spouse. Each of these kills the S election the day it happens, whether or not anyone intended it.

Creating a Second Class of Stock

An S corporation may have only one class of stock, meaning every share must carry identical rights to distributions and liquidation proceeds.³ Differences in voting rights alone do not violate the rule; voting and non-voting common stock are both permissible.⁵

Trouble starts when economic rights diverge. Issuing preferred stock with a dividend preference, entering a binding agreement that gives one group of shareholders priority on distributions, or structuring a purported loan that the IRS recharacterizes as equity can all create a second class of stock and terminate the election. The determination rests on the rights laid out in the corporate charter, articles of incorporation, and applicable state law, not on the labels the parties use.

Becoming an Ineligible Entity

Certain corporations cannot be S corporations at all. The list includes insurance companies taxed under Subchapter L, financial institutions using the reserve method of accounting for bad debts, and domestic international sales corporations (DISCs) or former DISCs.³ If the corporation’s business activities change so that it falls into one of those categories, the S election terminates on the date of the change.

Three Years of Excessive Passive Income

The third trigger is narrower. It applies only to S corporations that carried over accumulated earnings and profits (AE&P) from years when they were C corporations. A corporation that has always been an S corporation, or one that has already distributed all of its C corporation AE&P, is immune to this rule and can earn unlimited passive income without any termination risk from this provision.

For corporations that do carry AE&P, termination requires two conditions to hold for three consecutive tax years. The corporation must have Subchapter C accumulated earnings and profits at the close of each of those years, and more than 25% of its gross receipts for each year must be passive investment income.² If both hold across all three years, the election terminates on the first day of the fourth year.

What Counts as Passive Investment Income

The statute defines passive investment income as gross receipts from royalties, rents, dividends, interest, and annuities. Gains from selling stock or securities feed into the calculation to the extent of net gains. Several exceptions carve out income that would otherwise look passive:²

Rental income earned in the active conduct of a trade or business may be excluded, though that line is frequently litigated.
Interest on notes received from selling inventory in the ordinary course of business is not passive investment income.
Dividends from a C corporation subsidiary in which the S corporation owns at least 80% are excluded to the extent they come from the subsidiary’s active business earnings.
Banks and qualifying lending or finance companies can exclude interest income and certain dividends from the calculation.

The Annual Penalty Tax

The three-year clock is not the first sign of trouble. In any single year an S corporation with AE&P exceeds the 25% passive income threshold, it owes a corporate-level tax on its excess net passive income, calculated at the highest rate under Section 11(b), currently 21%.⁶ The penalty tax is a warning to fix the income mix or distribute out the AE&P before the third year closes and the election dies.

After the Election Ends

When termination hits on a date other than the first day of the tax year, the year splits into two short tax years. The S short year runs from the start of the year through the day before termination. The C short year begins on the termination date and runs through year-end. The corporation files Form 1120-S for the S short year and Form 1120 for the C short year, with income, deductions, and credits split between the two. The default allocation is pro-rata by day, but the corporation can elect to close the books on the termination date if every shareholder who held stock during the S short year and on the first day of the C short year consents.⁷

Once the C short year begins, income faces the flat 21% corporate rate and distributions to shareholders are treated as dividends. Shareholders no longer receive Schedule K-1s reporting their share of business income and losses.

The Five-Year Wait Before Re-Electing

After any termination, whether voluntary or involuntary, the corporation and any successor corporation must wait five tax years before making a new S election. The clock starts from the first tax year for which the termination was effective. The IRS can waive the waiting period, but the corporation has to request consent.²

Inadvertent Termination Relief

When a termination was genuinely accidental, the IRS has authority to treat the S election as though it never ended. The corporation must show that the disqualifying event was not planned, that it took corrective action once it discovered the problem, and that the corporation and shareholders agree to whatever adjustments the IRS considers appropriate. If relief is granted, everyone is treated as if the election was continuously in effect.²

Some inadvertent terminations qualify for automatic relief under Revenue Procedure 2013-30, which covers common situations like late-filed elections. Those require no private letter ruling and no user fee. Situations that don’t fit the automatic procedures require a private letter ruling. The IRS user fee starts at $14,500, before professional fees.⁸

A handful of states impose their own entity-level taxes on S corporations or do not fully recognize the federal S election, so a federal termination can also change state tax treatment. Checking state-specific rules is worth doing whenever a termination event is on the horizon.

1
Internal Revenue Service. Revoking a Subchapter S Election
2
Office of the Law Revision Counsel. 26 U.S. Code 1362 – Election; Revocation; Termination
3
Office of the Law Revision Counsel. 26 USC 1361 – S Corporation Defined
4
Internal Revenue Service. S Corporations
5
eCFR. 26 CFR 1.1361-1 – S Corporation Defined
6
Office of the Law Revision Counsel. 26 U.S. Code 1375 – Tax Imposed When Passive Investment Income of Corporation Having Subchapter C Earnings and Profits Exceeds 25 Percent of Gross Receipts
7
eCFR. 26 CFR 1.1362-3 – Treatment of S Termination Year
8
Internal Revenue Service. Internal Revenue Bulletin 2026-1