Section 1377(a)(1) generally provides each shareholder of an S corporation is allocated income or loss of the corporation by (a) assigning an equal portion of each item of income or loss to each day of the year, and (b) dividing that portion pro rata among the shares outstanding on that day. For example, if there is $365 of taxable income for the year, $1 of income is allocated to each day. That $1 is allocated among the shareholders pro rata based on stock ownership on that day.

Because the default rule of Section 1377(a)(1) may be inequitable in some cases where a shareholder terminates his or her interest in the corporation mid-year, Section 1377(a)(2) permits a closing of the books method. If the election is made, allocations are made to the exiting shareholder as if there are two tax years — one from the beginning of the year until the shareholder’s termination and a second from the shareholder’s termination until the end of the year.

The 1377(a)(2) election may benefit or disadvantage the exiting shareholders depending on the timing within the year of the corporation’s income. For example, assume S (seller) and B (buyer) are the only shareholders of S corporation SB. S and B each owns 100 shares. On March 31, 2022, B buys S’s stock. Taxable income from January 1, 2022, through March 31, 2022, is $500. Taxable income for the entire year is $700. S’s allocation of income could be $250 or $87.50 depending on whether a Section 1377(a)(2) election is made. If it is not made, the allocation is $87.50 because that is the pro-rata annual income for 3 out of the 12 total months, multiplied by 50%. If the election is made, S is allocated 50% of the income in the first quarter, which is $250. S would obviously prefer to forgo the election. Because the election requires the consent of the terminated shareholder and all other shareholders, S will not consent to the election if she is well-advised. Although additional income allocated to S would increase her tax basis and reduce her gain on the sale, the additional income will in most cases be ordinary while the additional gain is capital that will usually be taxed at a favorable long-term capital gain rate.

The 1377(a)(2) election is made by attaching a statement to the S corporation’s tax return for the year in which a shareholder’s interest was terminated. Because the terminated shareholder and the remaining shareholders generally have adverse interests, it is best to address whether the election will be made in the sale agreement.

John G. Hodnette is an attorney with Johnston, Allison & Hord in Charlotte.

February 28, 2023/by TAX