What Is a Closing-of-the-Books Election?

A closing-of-the-books election is a choice an S corporation can make under Internal Revenue Code Section 1377(a)(2) to split its tax year into two segments on the day a shareholder’s entire interest ends, so income, losses, deductions, and credits are allocated based on when they actually occurred rather than spread evenly across all 365 days.¹ Without it, a shareholder who exits in February can be taxed on profits the business earns in October. With it, the books effectively close on the departure date and reopen the next day.

Why the Default Rule Creates the Problem

S corporations pay no federal income tax at the entity level. Income, losses, deductions, and credits pass through to shareholders in proportion to their stock ownership.² Under the default per-share, per-day method in Section 1377(a)(1), the corporation takes its total annual results, divides them equally across every day of the tax year, and then allocates each day’s slice among the outstanding shares.¹

Consider a two-person S corporation, 50/50 ownership. The business earns $60,000 in the first half of the year and $140,000 in the second half. One shareholder sells all their stock on June 30. The per-share, per-day method doesn’t care that most of the income arrived after they left. It spreads the full $200,000 evenly across the year and allocates roughly $100,000 to the departing shareholder. Under a closing-of-the-books election, that shareholder would instead be allocated $30,000: half of the $60,000 actually earned while they still owned stock.

When the Election Is Available

The election is available only when a shareholder’s entire interest in the S corporation ends during the tax year. A partial sale or reduction in ownership does not qualify. The Treasury Regulations list five events that terminate an interest:³

Sale or exchange of all shares to another party.
Gift of all shares under Section 102(a).
Transfer of all shares to a spouse or former spouse under Section 1041(a), including in divorce.
Redemption of all the shareholder’s shares by the corporation.
Death of the shareholder.

After the event, the individual or estate must hold zero legal or beneficial interest. A single retained share defeats the election for that transaction.

How the Allocation Works Once Elected

When the election is in place, the corporation treats its tax year as two separate periods for allocation purposes. The first period runs from the start of the tax year through the close of the day the shareholder’s interest terminates. The second begins the next day and runs to the end of the corporation’s normal tax year.¹

This requires an actual accounting cutoff. Revenue and expenses are calculated for each segment specifically, not estimated by proration. The books are closed twice, in effect, and the payoff is that each shareholder is taxed on results tied to their real period of ownership.

One nuance: the election adjusts the allocation only for “affected shareholders” as defined in the statute. Anyone else who held stock during the year continues to receive a per-share, per-day allocation.¹

Who Has to Consent

The statute requires the corporation and every affected shareholder to agree. Who counts as affected depends on how the stock changed hands:⁴

If the departing shareholder sold or gifted the stock to another person, the affected shareholders are the departing shareholder and anyone who received shares from them during the tax year.
If the corporation redeemed the stock, every person who was a shareholder at any point during the tax year is affected.

The redemption rule is where negotiations get difficult. A single minority holder who owned stock at any time during the year can block the election by withholding consent. There is no majority override and no way for the IRS to force it. Without unanimous agreement from the affected group, the corporation reverts to the default method.¹

How to Make the Election

The corporation prepares a written election statement and attaches it to Form 1120-S for the year the terminating event occurred. Treasury Regulation Section 1.1377-1(b)(5) specifies four elements:³

A declaration that the S corporation is electing under Section 1377(a)(2) to treat the tax year as if it consisted of two separate tax years.
A description of the terminating event, including when and how the shareholder’s entire interest ended.
A statement that the corporation and each affected shareholder consent to the election.
The signature of an authorized corporate officer, under penalties of perjury. For tax years beginning after December 31, 2002, this is satisfied by the officer’s signature on the Form 1120-S itself.

The regulation does not require individual signed consents from each affected shareholder. The officer’s signature on the return handles the perjury requirement. Even so, many practitioners collect separate written consents from each affected shareholder as documentation against later disputes.

The filing deadline is the corporation’s Form 1120-S due date: the fifteenth day of the third month after the close of the tax year, which is March 15 for calendar-year filers.⁵ If the corporation files Form 7004 for a six-month extension, the election is timely as long as the statement is attached to the return filed by the extended deadline. Electronic filers attach the signed statement as a PDF.

The Form 1120-S instructions also allow the election to be made on a timely filed amended return.⁶ A corporation that filed without the election and later obtains the required consents can add it by amending. Once accepted, the election is generally irrevocable for that terminating event.

On Schedule K-1, the corporation must write “Section 1377(a)(2) Election Made” at the top of each affected shareholder’s K-1.⁶ The dollar amounts on those K-1s reflect the actual results of the shareholder’s ownership period rather than a full-year pro-rata share. Separate K-1s are not required; the notation and adjusted figures handle the reporting on a single K-1. Unaffected shareholders receive their K-1s under the standard method with no notation.

When It Helps and When It Hurts

The election benefits whichever side of the transaction ends up in the period with lower income or higher losses. A shareholder selling before a strong second half avoids being taxed on profits earned after they left. A buyer taking on stock right before a significant loss captures more of that loss than the per-share, per-day method would give them.

That built-in tension is why the law demands consent. If most of the year’s income was earned before the departure and losses are expected afterward, the departing shareholder has no reason to agree. Flip the numbers and the buyer or remaining shareholders resist. The election is a routine negotiating point in S corporation stock purchase agreements, and experienced parties price it into the deal.

What the Election Does Not Cover

Two boundaries are worth knowing before assuming the election fits a given situation.

First, a different mechanism exists for shareholders who don’t fully exit. Under Treasury Regulation Section 1.1368-1(g)(2)(i), a “qualifying disposition” election is available when a shareholder sells or redeems at least 20 percent of the outstanding stock, or the corporation issues new stock equal to 25 percent or more of previously outstanding shares, without the shareholder’s interest ending completely.⁷ If the same transaction is both a qualifying disposition and a complete termination, only the Section 1377(a)(2) closing-of-the-books election is available; the qualifying disposition route cannot be used when the shareholder’s entire interest ends.

Second, the federal election does not automatically bind the states. Some states follow the federal treatment without a separate filing; others require their own election or apply different allocation rules for pass-through entities. If the corporation operates in multiple states or has shareholders in different states, confirm each state’s rules before assuming the federal election carries over.

1
Office of the Law Revision Counsel. 26 USC 1377 – Definitions and Special Rule
2
Internal Revenue Service. S Corporations
3
eCFR. 26 CFR 1.1377-1 – Pro Rata Share
4
Legal Information Institute. Definition: Affected Shareholders From 26 USC 1377(a)(2)
5
Internal Revenue Service. Publication 509 (2026), Tax Calendars
6
Internal Revenue Service. 2025 Instructions for Form 1120-S
7
eCFR. 26 CFR 1.1368-1 – Distributions by S Corporations