When a shareholder terminates part or all of their interest in an S corporation, IRC Section 1377(a)(2) allows the S corporation to elect to have two separate periods within a taxable year. This treatment is often referred to as ‘closing the books.’
Generally, determination of income and expenses is on a per-share, per-day basis based on the entire taxable year. By making this election, a shareholder is allocated the portion of income and expenses from the beginning of the year until their termination date, rather than the entire year. This effectively creates two taxable periods within one taxable year thereby creating certainty of the income tax liability of entering or exiting shareholders/members and the remaining shareholders/members.
This election requires a statement signed by the individual authorized to sign the corporation’s tax return and also requires the written consent of all S corporation shareholders who were a shareholder at any time during the taxable year.
Making this election can be extremely valuable in scenarios involving shareholders/members entering or exiting an S Corporation and consideration should be given prior to the signing of any agreement.