When a shareholder of a corporation that has elected under Internal Revenue Code §1362 to be an S corporation is planning to sell the shareholder's stock, the seller and the purchaser (or purchasers) should consider how items of income, gain, loss, deduction and credit of the corporation for the year of the sale will be allocated as between the selling shareholder and the purchasers (collectively the “affected shareholders”), taking into account that all such items flow through to S corporation shareholders under the relevant Code provisions. If the selling shareholder's stock is being redeemed by the corporation, all of the remaining shareholders will be affected by this allocation.

The focus of the brief summary of allocation possibilities below is on the choices available where the selling shareholder (sometimes referred to as the “terminating shareholder”) is transferring all of the shareholder's stock, in a transaction that is not expected to result in the termination of the status of the corporation as an S corporation.

Absent any contrary election, §1377 and regulations thereunder mandate allocation among the affected shareholders on the basis of chronological proration: An equal portion of each tax item is assigned to each day of the taxable year of the corporation, and that item is then divided pro rata among all the shares outstanding on that day. Thus, for example, if a 50 percent shareholder sells all of the shareholder's stock on the 91st day of the corporation's calendar taxable year of 365 days, under the default rule the selling shareholder will be allocated 50 percent of 91/365ths (altogether, approximately one-eighth) of each of the corporation's tax items for the year in which the sale occurs.