Key Takeaways

  • Converting a C corp to an S corp affects how retained earnings are taxed and distributed.
  • Accumulated earnings from the C corp period may be subject to built-in gains (BIG) tax if assets are sold post-conversion.
  • Passive income from C corp–era retained earnings can trigger termination of S corp status if limits are exceeded.
  • Planning strategies include tracking earnings and profits (E&P), avoiding excess passive income, and managing appreciated assets.
  • A five-year holding period often applies to avoid the BIG tax on asset sales after conversion.
  • An S corp can maintain retained earnings, but shareholders must still pay taxes on all profits, whether distributed or not.
  • Legal counsel or a tax advisor can help mitigate tax liabilities and ensure compliance during the conversion process.

Knowing the C corp conversion to S corp retained earnings is important for calculating taxes. Many business owners wish to set up their corporation as a subchapter or S corporation to be able to take advantage of pass-through taxation and other benefits. It is important to note that all profits of an S corporation are taxed, including what has become your retained earnings.

Basics of an S Corporation

In a typical corporation, the corporation will pay income taxes on the profits they make for that year. After the taxes have been paid, the remaining profit will either be paid as dividends to the shareholders or reinvested into the company which will become retained earnings.

If a company receives S corporation status from the IRS, they will not be required to pay corporate-level taxes and instead the profits from the company will pass-through the company to the personal returns of the shareholders. The portion of the profit that each shareholder will have to report on their tax return will be directly related to the percentage of the company that they own.

Eligibility Requirements for S Corporation Status

Before converting a C corp to an S corp, ensure your business meets the IRS eligibility requirements for S corporations:

  • Must be a domestic corporation.
  • Can have no more than 100 shareholders.
  • Shareholders must be U.S. citizens or resident individuals (certain trusts and estates also qualify).
  • Must have only one class of stock.
  • Cannot be an ineligible corporation (e.g., certain financial institutions or insurance companies).

Failure to meet these requirements can result in automatic termination or rejection of S corporation status, complicating your tax situation.

Retained Earnings

An S corporation can handle their profits in the same way that a c corporation does. They can disperse them to shareholders, keep them as retained earnings, or do a combination of both. The difference is that the shareholders of an S corporation will pay taxes on all of the corporation's profits no matter what the business does with the income.

Retained Earnings and Accumulated Earnings & Profits (E&P)

When you convert a C corp to an S corp, retained earnings accumulated under C corp status become part of the S corp’s accumulated earnings and profits (E&P). This distinction is important because:

  • The IRS treats E&P separately from current-year S corp income.
  • Distributions must first come from S corp income, but any excess may draw from E&P, potentially triggering dividend treatment (and taxation) rather than tax-free distributions.

Maintaining accurate records of C corp E&P is crucial to avoid tax surprises and ensure correct treatment of distributions post-conversion.

The Problem With Retained Earnings

It is with retained earnings that taxes can become a problem with an S corporation designation. The shareholders of an S corporation will have to pay taxes on the profits whether or not they receive distributions. It is always important to continue to reinvest in a company, but with an S corporation, the owners are paying taxes on that money even if they never personally benefit from it.

This can be problematic for silent partners who do not have a say in the reinvesting of the company but need to pay taxes on that money whether or not they receive it.

Built-In Gains (BIG) Tax and Retained Earnings

A major tax implication of converting C corp to S corp retained earnings is the potential for Built-In Gains (BIG) Tax. This tax applies if:

  • The S corp sells appreciated assets (acquired during C corp status) within five years of conversion.
  • The appreciation occurred before the conversion to S corp status.

The BIG tax is imposed at the highest corporate rate on the gain and is separate from the individual-level tax on S corp income. Planning to defer asset sales or waiting out the five-year period can help avoid this tax burden.

Evaluating an S Corporation Status

Determining whether or not an S corporation status is right for your business will depend on your circumstances. You should weigh the fact of paying taxes on profits you may or may not receive against the tax benefits that come with the S corporation status. One of the tax benefits is that personal tax rates are often lower than corporate rates, which means less payment on overall taxes. C corporation also is subject to being taxed twice. You should not make the decision lightly because if you have an S corporation status and give it up, you will be required to wait five years until you reapply.

Risks of Excess Passive Income from Retained Earnings

Retained earnings tied to passive income can pose risks to your S corp election. Passive income includes:

  • Rent
  • Interest
  • Dividends
  • Royalties

If your S corp has accumulated E&P from its C corp days and generates more than 25% of gross receipts from passive income for three consecutive years, it risks automatic revocation of S status.

To avoid this:

  • Consider distributing E&P to reduce risk.
  • Shift the business model to generate more active income.
  • Reclassify passive income where legally appropriate.

Tax Consequences of Converting a C Corporation to an S Corporation

When choosing between C corporation and S corporation status, it is important to realize the distinction between the two. A corporation is a formal organization complete with shareholders, a board of directors, and officers. When choosing an S corporation status, it will be treated more like a partnership or limited liability company. Some of the tax issues to consider when deciding include:

  • Owner advantages: When changing from a C corporation to an S corporation the taxes will be subject to the lower personal tax rate of the owners.
  • Big taxes: Your company may be subject to big taxes if the previous corporation sells assets for profit.
  • Big limitations: You must gold major assets of a corporation for five years after converting to an S corporation to avoid paying heavy taxes.
  • No inherited taxes: You are not allowed to claim the previous losses that have been inherited by the c corporation passing through onto the owner's personal tax return. You also may be taxed on inventory inherited from a C corporation.
  • Passive income: When converted to an S corporation you may also have to pay taxes on passive income that has been inherited from the C corporation. This type of passive income can include such things as rent, interest, retained earnings, royalties, or the funds that have come from stock sales.

Strategic Planning for a Smooth Conversion

Successfully converting a C corp to an S corp while managing retained earnings involves careful planning:

  • Track E&P separately to avoid dividend misclassification.
  • Avoid early asset sales to reduce exposure to BIG tax.
  • Distribute excess E&P to reduce the risk of termination from excess passive income.
  • Review ownership and shareholder structure to ensure IRS eligibility.
  • Conduct a pre-conversion tax review with a qualified tax advisor.

While the S corp election offers significant tax advantages, mishandling retained earnings can lead to unintended taxes and complications. If you're unsure how to proceed, you can post your legal need on UpCounsel to find an experienced attorney who can help with S corp conversions and tax strategies.

Frequently Asked Questions

  1. What happens to retained earnings when converting from C corp to S corp?
    They become part of accumulated earnings and profits (E&P) and may be subject to taxation if distributed or tied to passive income.
  2. Can S corporations keep retained earnings?
    Yes, but shareholders must still pay taxes on all income, even if it's retained and not distributed.
  3. What is the Built-In Gains (BIG) tax and when does it apply?
    The BIG tax applies if an S corp sells appreciated assets from its C corp period within five years of conversion.
  4. How does passive income affect S corp status post-conversion?
    Too much passive income (over 25% of gross receipts for three years) combined with E&P can cause the IRS to terminate S status.
  5. Should I consult a tax advisor before converting to an S corp?
    Absolutely. Tax advisors can help navigate the BIG tax, E&P tracking, and compliance to ensure a smooth and tax-efficient transition.

If you need help with C corp conversion to S corp retained earnings, you can post your legal need on UpCounsel's marketplace. UpCounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.