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When a shareholder joins or leaves an S corporation during the year it can cause many problems. Among these problems is the question of how to allocate income for tax purposes. The Internal Revenue Service (IRS) has issued regulations to clarify how to deal with some of these situations.
The general rules specify that shareholders must be allocated income prorated on a per-share, per-day basis. However, there is a rule that provides that if a shareholder disposes of his or her entire interest during a year, the shareholders may elect to actually close the books as of the date of that disposition. To do this, however, every person who was a shareholder on any day during that year must consent. However, as the year would be deemed ending on the day the interest was disposed, I do not believe that the new shareholder would be allowed to vote, as he was not a shareholder in the year ending on the day of transfer (unless he owned a portion of the company and was just increasing his ownership).
This election isn't as simple as it sounds. Although you are closing the book as of the date of disposition, the corporation will not file two tax returns for that period. Instead, the corporation files one return at the same time that it would have been due if there had been no disposition. The only purpose of the allocation is to properly give the retiring (or new) shareholder their "proper" share of the income or loss of the business..
As I stated above, the rules allowing for an actual closing of the books are applicable only when a shareholder disposes of his or her entire interest in the corporation. However, the IRS has relaxed this requirement. In regulations under Internal Revenue Code §1368, the IRS has determined that if there is more than a 20% change of ownership in the corporation during a year, the corporation may elect, by consent of all of its shareholders, to allocate income on an actual closing of the books basis as of the date the change of ownership hits 20% during any taxable year. This is a significant liberalization of the rules and will provide needed flexibility, but also unwanted complexity.
So, in answer to your question, ALL shareholders must consent to the closing of the books. This means all persons who owned any part of the corporation during the year. The Board of Directors or an officer of the corporation should notify all shareholders and confirm the proper vote. The election is permanent. Like all matters with our tax code, compliance is enforced through the threat of audit. We are voluntarily compliant, and the tax returns that we file are signed under penalty of perjury. That means that the IRS can impose larger fees and even jail time for lying on the tax return.
I do not believe that it can be contested. As the election must be unanimous, there should be no need to contest it. The person who would contest can just vote "no" and stop the election.
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