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

An S corporation makes a Section 1377(a)(2) election when a shareholder fully exits the company during the tax year and the owners want income, losses, deductions, and credits allocated based on what actually accrued before and after the departure, not spread evenly across the calendar. The election closes the books as of the termination date and splits the year into two short periods, so the departing shareholder picks up only what they earned while they held stock and the remaining shareholders pick up only what came after.

Without the election, the IRS applies a daily pro rata formula that ignores when the corporation actually made or lost money. That can hand a departing owner tax on fourth-quarter profits they had no part in, or saddle a new buyer with first-quarter losses that predated their investment.

Why the Default Rule Causes Problems

Under Section 1377(a)(1), the corporation divides each item of income, loss, deduction, and credit equally across every day of the tax year, then allocates each day’s share to whoever owned stock on that day.¹ The math is mechanical: annual total divided by 365, multiplied by each shareholder’s ownership on each day.

That approach works when ownership stays constant. It breaks down when someone leaves mid-year and earnings aren’t spread evenly across the calendar. A retail business that books 70 percent of its profit in the fourth quarter will still allocate a chunk of those holiday profits to a shareholder who sold on March 31, because the default method doesn’t care when the money was earned. The same distortion runs the other way for the buyer. These misallocations then ripple 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

The election only applies when a shareholder completely exits the S corporation during the tax year. A sale of all shares, a full corporate redemption, a gift of the entire stake, or the death of a shareholder qualifies.¹ Dropping from 40 percent ownership to 10 percent does not. The statute draws a bright line at complete departure.

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

Redemptions carry an extra wrinkle. A redemption must first qualify as a sale or exchange under Section 302, and those tests apply the constructive ownership rules of Section 318, which attribute stock owned by family members to the redeeming shareholder.² If a redemption fails the Section 302 tests because of family attribution, it’s treated as a distribution rather than an exchange, and there’s no termination of interest to trigger the election.

Who Must Consent

The statute requires consent from the corporation and from all “affected shareholders.” The regulatory definition is narrower than many practitioners expect. Affected shareholders are the departing shareholder and every shareholder who received shares from the departing shareholder during the tax year.³ If the exit was a sale to one specific buyer, only the seller, the buyer, and the corporation need to sign off.

The consent group expands sharply in one scenario. When the departing shareholder’s stock was redeemed by the corporation rather than sold to another individual, every person who held stock at any point during the tax year becomes an affected shareholder whose consent is required.³ Redemptions are therefore harder to manage than third-party sales from an election standpoint. Shareholder agreements should address consent obligations before the transaction closes so the election doesn’t fall apart afterward.

How to Make the Election

The corporation makes the election by attaching a statement to its Form 1120-S for the year of the termination. The statement can go with either a timely filed original return or an amended return.⁴ A single statement covers all terminating elections made in the same tax year.

The statement needs four things:³

A clear declaration that the corporation is electing under Section 1377(a)(2) to treat the tax year as two separate short years.
The termination details, including when and how the shareholder’s interest ended.
A signature from an authorized officer under penalties of perjury.
Confirmation that the corporation and each affected shareholder consent.

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

Deadline

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’s March 15 of the following year, or September 15 with an extension. Because the regulations let the election ride on an amended return, a corporation that missed the original filing can still make it by amending.³ Once both windows close, 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 elected, the corporation closes its books on the termination date and computes income, losses, deductions, and credits for each short period using its normal accounting method. The first short period runs from the start 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 go only to those who held stock during that time, including the departing shareholder. Items from the second period go only to those who held stock afterward. The departing shareholder’s final K-1 reflects only what happened through their exit.

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

Effects on Basis, Distributions, and AAA

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

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

If the first period produced strong income, the AAA balance will usually cover any distributions made during that time and keep them tax-free. If the first period produced a loss, the smaller AAA can push distributions into taxable dividend territory to the extent of old earnings and profits, and capital gain beyond that.

Suspended Passive Losses at Departure

A shareholder who could not deduct passive activity losses from the S corporation in prior years gets a final opportunity when they dispose of their entire interest. Previously suspended passive losses become fully deductible in the year of disposition.⁶ This applies whether or not the corporation makes the 1377(a)(2) election.

Suspended passive activity credits don’t get the same treatment. You cannot claim unused credits simply because you left the corporation. You can elect to increase the basis of the property that generated the credit by the portion of unused credit that previously reduced that property’s basis, but the credits themselves don’t convert into a deductible loss.⁶ For shareholders sitting on large suspended losses, this often makes the year of departure the most tax-efficient exit point.

If the Shareholder Isn’t Fully Leaving

The Section 1377(a)(2) election is not available for a partial reduction in ownership. A different provision, Treasury Regulation 1.1368-1(g), covers “qualifying dispositions,” which include a sale or redemption of 20 percent or more of outstanding stock within a 30-day window, or the issuance of new stock equal to 25 percent or more of previously outstanding shares within a 30-day period.⁷

The two elections are mutually exclusive for the same transaction. If the event qualifies as a complete termination under 1377(a)(2), that election applies and the 1.1368-1(g) election is unavailable.⁷ When a major shareholder reduces a stake without fully exiting, the 1.1368-1(g) election can achieve a similar books-closing effect for distribution purposes. Matching the right election to 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. Topic No. 425, Passive Activities – Losses and Credits
7
Internal Revenue Service, Treasury. 26 CFR 1.1368-1 – Distributions by S Corporations