How to Convert a C Corporation to an S Corporation (And Whether You Should)
May 21st, 2020
Since the implementation of the federal Tax Cuts and Jobs Act (TCJA) a couple of years ago, our office has received many inquiries about the benefits of converting an existing C corporation to an S corporation. In this article, we will briefly discuss the benefits of doing so, and the specifics of actually converting a C corporation to an S corporation.
A C or S corporation is so called because the rules regarding its taxation are found in Subchapter C or Subchapter S of the Internal Revenue Code. C corporations are the default; a business must elect to become an S corporation, which might be done at the time of formation, or sometime thereafter.
Each type of corporation has its advantages, which you are probably familiar with if you are thinking about a conversion from one to the other. Very briefly, C corporations are taxed on their profits, and if those profits are distributed to shareholders, the shareholders pay income tax on those distributions.
Why Convert From a C Corporation to an S Corporation?
Although the TCJA lowered the tax rate for C corporations to 21% in 2018 (down from a rate of 35%), there are still benefits to electing S corporation status. The first is to avoid double taxation on corporate profits, especially for smaller C corporations that will distribute most of their profits to one or two shareholders.
S corporations are called “pass-through” entities because income passes through the entity for taxation purposes, and is claimed on the owner’s income tax return. Under the TCJA, some pass-through business owners can claim a deduction of up to 20% of qualified business income (QBI) on their income tax return. Owners of a pass-through can also directly deduct net operating losses on their personal income tax return, using them to offset other personal income. Losses to a C corporation can only be deducted against corporate profits. These losses do not pass through to shareholders.
There are potential tax implications of converting from a C corporation to an S corporation, the most notable of which is the Built-In Gains (BIG) tax. This is imposed on the first 35% of appreciated property of the converted corporation, but is only realized if the appreciated assets are sold within a specified period following the first day of the first tax year after conversion to S corporation status. This period, originally 10 years, has subsequently been reduced first to seven, then to five years by federal legislation. In order to determine BIG tax, the corporation must determine the amount of unrealized gain for each asset at the time of conversion to an S corporation.
Let’s say that Smith Corp was originally a C corporation and converted to an S corporation on January 1, 2019. While a C corporation, Smith Corp acquired real estate, which appreciated in value by $100,000 before the conversion. Smith Corp sells the real estate one month after the conversion. It will most likely have to pay C corporation taxes on the appreciation, even though the sale took place after the company became an S corporation.
Despite the prospect of BIG tax, S corporation status still offers clear advantages for many corporations. If you have decided that it makes sense to convert your C corporation to an S corporation, how do you go about doing so?
State and Federal Requirements for Converting a C Corporation to an S Corporation
The first order of business is to be sure that your C corporation is eligible to be converted to an S corporation. An S corporation may have only a limited number of shareholders, generally 100 or less. (in some cases, family members can be treated as one shareholder.) The corporation may have only one class of stock, and all shareholders must be either U.S. citizens or lawful permanent residents (green card holders).
If your C corporation is eligible for S corporation status, you need to complete IRS Form 2553, Election By a Small Business Corporation. The form needs to be signed and dated by a corporate officer with the authority to sign on the corporation’s behalf. In addition, all of the corporation’s shareholders must give their written consent to the conversion. Ohio corporations must file a Notice of Subchapter Selection with the Ohio Department of Taxation.
There is a specific time frame in which the conversion must be made. A filing is considered timely if it is made no more than two months and fifteen days after the beginning of the tax year in which the election of S corporation status is to take effect. An election is also timely filed at any time during the tax year preceding the tax year in which it is to take effect. If an S corporation election is filed late, the corporation must indicate this by entering “FILED PURSUANT TO REV. PROC. 2013-30” in the top margin of the first page of Form 2553.
A late election can also be made by attaching Form 2553 to Form 1120S, US Income Tax Return for an S Corporation. In that case, a notation must be made on Form 1120S to indicate that the form includes a late election.
Filing a late election of S corporation status can have serious financial consequences. The corporation will continue to be taxed as a C corporation. There may be penalties for late filing and payment, as well as interest on unpaid taxes. Furthermore, if the business filed taxes as an S corporation using Form 1120S, filings for previous tax years may be considered open and subject to IRS scrutiny.
If you have questions about the pros and cons of converting a C corporation to an S corporation, or need assistance with preparing and filing the necessary documents, please contact Gudorf Law Group to schedule a consultation.