When an S Corporation shareholder’s interest is terminated during the year, the shareholder’s allocation of income, losses, and deductions is generally computed by applying percentage to the full-year activity of the corporation. Terminating interest in the middle of the year is a complex matter because items are prorated on a per-share, per-day basis.

For example, you and other shareholder are 50/50 owners of an S corporation. The corporation shows a $500,000 loss from January 1 through June 30. Your partner wants out and sells everything to you. You continue to run the corporation through the rest of the calendar year. The corporation actually turned a profit of $500,000 for the entire year. Since your partner is not participating in management or ownership of the company from July 1 through Dec. 31, he will not be entitled to compensation or distributions based on profits. However, your partner will receive a schedule K-1 showing approximately $125,000 of income without having received any distributions.

This is ($500,000 profit for the whole year)(.50 ownership)(.50 of the year) = 125,000. This is greatly unfair to your partner.

To circumvent this, both of you must agree to close the books (Election to Close Books) at the date of disposal so the tax year will be divided into two short years. This will allocate items to your partner only up to date of disposition of his interest. And start a new book after the date of disposition. If both shareholders elected to close books at the date of disposition, the leaving shareholder will get K1 with $250,000 loss.

Refer to 26 U.S. Code § 1377 for more information.

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