1. Basics of an S Corporation
2. Retained Earnings
3. The Problem With Retained Earnings
4. Evaluating an S Corporation Status
5. Tax Consequences of Converting a C Corporation to an S Corporation

Updated November 4, 2020:

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.

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.

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.

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.

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.

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