The right entity choice: Should you convert from a C to an S corporation?

A business can elect to switch from filing as a C Corporation to an S-Corporation, and the principal advantage of this conversion is to escape the double tax regime of Corporation status as the profits and losses of the corporation are now passed through to the individual shareholders and reported on the individual shareholder’s personal tax return. The decision to operate as a “flow-through entity” can affect your business in several ways, including the amount of your tax bill. Although S corporations can provide substantial tax benefits over C corporations in some circumstances, there are potentially costly tax issues that you should assess before making the decision to convert from a C to an S corporation.

Here are four issues to consider:

1. LIFO Recapture tax. A C corporation that uses the last-in, first-out (LIFO) inventory method must pay tax on the benefits it derived from using the LIFO method upon conversion to an S corporation. This tax is known as the “LIFO recapture tax” and can be spread over four years. The first installment must be paid by the due date (determined with regard to extensions) of the last C corporation return filed before conversion. This cost must be weighed against the potential tax gains from converting to S status.
2. Built-in gains tax. When a C corporation makes an “S” election, it becomes subject to the built-in gains tax on any appreciated property that is owned by the corporation on the effective date of the election that is disposed within the five-year period following the effective date of the election. Disposal or disposition of assets is defined very broadly for purposes of the built-in gains tax. The built-in gains tax can be avoided by maintaining all assets that were on hand at the date of the “S” election inside the corporation for the full five-year period following the date of the election.
3. Tax on excess net passive income. The excess net passive income tax is imposed on an S corporation that has accumulated earnings and profits that carry over from its former C Corporation years, and its passive investment income exceeds 25% of the corporation’s gross receipts. Passive investment income generally includes dividend, interest, rent, royalty, and capital gains.). If the excess net passive income tax is owed for three consecutive years, the corporation’s “S” election terminates. The excess net passive income tax and possible involuntary termination of the S election can be avoided by distributing the C corporation accumulated earnings and profits to the shareholders, which would be taxable to them as a dividend. Alternatively, the tax can be avoided through tax planning to limit the amount of passive income generated by the corporation during the tax year or subsequent tax years.
4. Unused losses. C corporation net operating losses (NOLs) generally cannot be used to offset income generated by the corporation after the effective date of its “S” election. The exception to this rule is that these NOLs can be used to offset net recognized built-in gains and reduce or eliminate any potential built-in gains tax incurred during the five-year period following the effective date of the “S” election. If the losses can’t be carried back to an earlier C corporation year or be utilized to offset any potential built-in gains tax incurred after conversion to an S corporation, it will be necessary to weigh the cost of losing these losses against the tax savings expected to be generated by the conversion to S status.

Other considerations

When a business switches from C to S status, these are only some of the factors to consider. For example, shareholder-employees of S corporations cannot take advantage l of the tax-free fringe benefits that are available to shareholder-employees of a C corporation. There also may be issues for shareholders who have outstanding loans from their qualified plans. These factors have to be taken into account to fully understand the tax implications of converting from C to S status.

If you’re interested in an entity conversion, contact a professional advisor at KraftCPAs. We can explain what your options are, how they’ll affect your tax bill, and possible strategies you can use to minimize taxes.

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