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If a shareholder terminates his or her interest in an S corporation during the tax year, the S corporation, with the consent of all affected shareholders (including those whose interest is terminated), may elect to allocate income and expenses, etc., as if the corporation’s tax year consisted of 2 separate tax years, the first of which ends on the date of the shareholders termination.
To make the election, the corporation MUST attach a statement to a timely filed original or amended Form 1120S for the tax year for which the election is made. In the statement the corporation must state that it is electing under section 1377(a)(2) and Regulations section 1.1377-1(b) to treat the tax year as if it consisted of 2 separate tax years. The statement must also explain how the shareholder’s entire interest was terminated (e.g., sale or gift), and state that the corporation and each affected shareholder consent to the corporation making the election. A single statement may be filed for all terminating elections made for the tax year. If the election is made, write “Section 1377(a)(2) Election Made” at the top of each affected shareholders Schedule K-1. If not filed on the original due date, an extension must be filed or else the actual filing will not be considerd timely.