C Corp To S Corp: Everything You Need to Know
C corp to S corp is a process that has a significant potential for valuation changes when a conversion takes place from a C corporation to a flow-through entity. 5 min read updated on January 01, 2024
C corp to S corp is a process that has a significant potential for valuation changes when a conversion takes place from a C corporation to a flow-through entity. When a conversion takes place, there is an increase in uncertainty in regard to the appraised valuation of an S corporation. A C corporation and an S corporation are similar in many ways, but the latter is a pass-through tax entity, meaning that taxes on its income are reported on its owner's personal tax returns. However, an S corp may not be the best option for all incorporated businesses because it comes with certain restrictions.
Steps to Convert a C Corporation to an S Corporation
Currently, filing Form 2553 is the only requirement to convert from a C corp to an S corp. File the form with the Internal Revenue Service (IRS) to change the tax election.
- All shareholders must sign the form.
- The timeframe for submitting the form can be no later than two months and 15 days from the beginning of the tax year. This will be the tax year when the S corp election is made. Form 2553, which is the Election by a Small Business Corporation, is then filed with the IRS.
- Form 1020S, which is the U.S. Income Tax Return for an S Corporation, must be filed in the tax year when the election is made.
Considerations About Converting From a C Corporation to an S Corporation
There are several factors to consider when converting from a C corporation to an S corporation. An important one is that the first $100,000 of annual income that a C corporation earns has a lower tax rate than the rate for high-income individuals. If the business is an S corporation, the tax rate is at a higher rate. For a C corporation, the average rate on $100,000 is estimated at 22.25 percent. For an S corporation, the rate is around 28 percent.
Converting from C to S corporation status can result in a bigger payout to owners and shareholders. As a C corporation, the lower taxes can support the company by allowing the enterprise to retain more of its after-tax cash.
Another benefit for taxpayers involves dividends and the tax rate. Single individuals pay a lower rate than upper-income individuals who may also be responsible for the Medicare surtax. So, for some individuals, the double taxation won't have as great an impact.
Something else to consider is the "built-in gains" tax. In most cases, built-in gains impose a tax rate on assets that have appreciated and are either sold by the former C corp or converted to cash within a 10-year timeframe once it has converted and changed its status to an S corporation. The tax cost of converting from a C to an S corp may be prohibitive since the tax is applied to low-basis inventories, zero-basis receivables, and any other corporate assets that have appreciated.
C Corporations and Taxes
The taxable income using federal rates for a C corporation can go up to 35 percent. Individual shareholders receiving distributions of dividends pay a 15 percent rate. The C corp cannot deduct dividends. The calculation used for distributed earnings received from a C corp look like this: 44.75 percent [(1 x 0.35) + (0.15 x 1 - 0.35)].
The following tax, financial, and legal considerations are associated with a C corp:
- The biggest difference between a C corp and an S corp is the tax election.
- Once a C corp has filed its articles of incorporation, has issued shares, and enacted a set of bylaws and once the first shareholder meeting has taken place, Form 2553 can be submitted to treat the C corp as an S corp.
- If the S election is not made within the specified time, the C corp remains a C corp until Form 2553 is filed.
- Moving from an independent tax entity (C corp) to a pass-through entity (S corp) will result in a difference in tax handling.
- If the S corp is a cash basis corporation, on the effective date of the S corp election, all of the accounts receivables are unrecognized as built-in gains. At some point when the receivables are paid, the revenue will be treated as a recognized built-in gain.
- Income tax is paid on untaxed profits generated when the corporation was a C corp. This is most common with appreciated real estate and uncollected accounts receivables.
- If converting to an S corp, tax must be paid on benefits accrued using LIFO inventories.
How to Elect S Corp Status?
Not all C corporations are eligible for S corp election. Your corporation must meet certain requirements in order to qualify for S corp status, including a capitalization requirement, shareholder requirements, corporate requirements, and requirements for corporations that have accumulated profits and earnings and certain levels of passive income.
- Shareholder requirements – An S corp can only have a maximum of 100 shareholders. In addition, only citizens or residents of the U.S. or certain trusts, estates, or tax-exempt organizations are allowed to be shareholders in an S corp.
- Corporate requirements – Only a domestic corporation that is not an insurance company taxable under subchapter L, a financial institution using the reserve method of accounting for bad debts under Section 585, a possessions corporation, or an existing or former domestic international sales corporation (DISC) is eligible for S corp status.
- Capitalization requirement – To elect S corp status, a corporation must have only one class of stock. This requirement can be a limitation when there is a desire or need to specially allocate corporate income to certain shareholders, such as shareholders who wish to receive a preferred return. Generally, a corporation can only meet these requirements with one class of stock if all outstanding shares grant equal rights to distributions and proceeds from liquidation. Nonetheless, normal commercial transactions between a corporation and its shareholders, such as leases and compensation arrangements, can be a violation of the one class of stock rule.
Switching from a C corp to an S corp is a multi-faceted decision that should be carefully thought out before making the final decision. Most importantly, you should weigh the tax consequences of the conversion against the benefits of electing S corp status. By doing so, you will be able to determine the best time to make the switch.
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