Key Takeaways

  • To convert a C corp to an S corp, file IRS Form 2553 within two months and 15 days of the start of the tax year, or request late election relief if eligible.
  • Only domestic corporations with 100 or fewer shareholders, one class of stock, and eligible shareholders (individuals, estates, or certain trusts) can qualify for S corp status.
  • Converting at the right time — such as during a low-valuation period — helps reduce built-in gains (BIG) tax exposure.
  • The BIG tax applies when appreciated assets are sold within five years of conversion; understanding asset valuation is crucial before converting.
  • Corporations must monitor passive income and accumulated earnings and profits (E&P) after conversion to maintain S corp status.
  • Failing to comply with IRS and state-level rules can result in loss of S corp status or unexpected double taxation.
  • Converting a C corp to an S corp is not a legal restructuring but a tax classification change; professional tax planning is strongly advised.

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.

  1. All shareholders must sign the form.
  2. 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.
  3. 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.

Pre-Conversion Planning and Eligibility Checks

Before filing Form 2553 to change from a C corp to an S corp, corporations should conduct a thorough pre-conversion review. This includes:

  • Confirming shareholder eligibility – All shareholders must be U.S. citizens or resident aliens, certain trusts, estates, or tax-exempt organizations.
  • Verifying stock structure – Ensure only one class of stock exists; any preferred stock or special allocations can disqualify the election.
  • Reviewing accumulated earnings and profits (E&P) – Excess E&P may trigger passive income penalties if not addressed before conversion.
  • Assessing state-level rules – Some states automatically recognize the S corp election, while others require separate filings or impose their own tax obligations.
  • Considering timing – Electing S corp status early in the fiscal year can maximize tax benefits and reduce compliance complications.

Detailed Asset Valuation and Timing Strategies

Before you convert a C corp to an S corp, conduct a comprehensive asset valuation to assess built-in gain exposure. The IRS imposes the built-in gains tax (BIG tax) on appreciated assets sold within five years after conversion. To minimize this, consider:

  • Timing the election strategically: Convert when the fair market value of assets is relatively low or before a major appreciation event.
  • Managing asset sales: Avoid disposing of high-value assets within the five-year recognition period unless the sale aligns with overall tax planning.
  • Evaluating depreciation recapture: Property that has been depreciated under C corp rules may trigger recapture income if sold post-conversion.
  • Reviewing installment sales: Installment sale income recognized after conversion may be subject to BIG tax if the sale originated under C corp status.

Thorough planning helps mitigate potential tax liabilities and ensures a smoother transition into S corp status.

Timeline and Deadlines for S Corporation Election

The deadline to switch from a C corp to an S corp is crucial for maintaining the intended tax status. If the election is not filed on time, the corporation remains a C corp for the entire tax year. The key deadlines to keep in mind include:

  • Standard Deadline: Form 2553 must be filed no later than two months and 15 days after the start of the corporation’s tax year for the election to take effect that year.
  • Late Election Relief: In certain cases, businesses that miss the deadline can request late election relief under IRS procedures. To qualify, the company must demonstrate reasonable cause for the delay and meet eligibility criteria.
  • Retroactive Election Considerations: Some corporations may seek retroactive S corp status, but this requires additional filings and IRS approval.

It is important to maintain accurate records and confirm IRS acceptance to ensure the switch is officially recognized.

Filing Procedures and IRS Documentation

To convert a C corp to an S corp successfully, filing IRS Form 2553 (Election by a Small Business Corporation) is the key procedural step. Each shareholder must sign the form, which must include:

  1. The corporation’s name, address, and EIN.
  2. The effective date of the S corp election.
  3. Details of all shareholders, including names, Social Security numbers, and stock ownership percentages.
  4. Signatures of all shareholders consenting to the election.

After filing, the IRS will issue a confirmation letter if the election is accepted. If errors occur, the corporation can request a private letter ruling for correction. Keeping organized shareholder records and maintaining clear communication with the IRS can prevent election delays.

Late Election Relief and Retroactive Status

If a corporation misses the two-month-and-15-day filing window for Form 2553, the IRS may grant late election relief if the business can show reasonable cause. Typical qualifying situations include:

  • Misunderstanding the filing requirements.
  • Reliance on incorrect professional advice.
  • Inadvertent administrative errors.

To request relief, the corporation must submit a detailed explanation and proof that it met all S corp eligibility rules as of the intended effective date. The IRS may also approve a retroactive election, allowing S corp status to apply from the beginning of the tax year, but this requires additional documentation and is not guaranteed.

Correcting Election Errors and Reasonable Cause Relief

If your corporation misses the election deadline or files an incomplete Form 2553, the IRS offers late election relief under Revenue Procedure 2013-30. To qualify:

  • The business must have intended to elect S corp status on the original effective date.
  • It must demonstrate reasonable cause for the failure (e.g., reliance on mistaken professional advice).
  • The corporation and shareholders must have filed all returns consistent with S corp treatment.

If approved, the IRS may grant retroactive S corp status back to the intended date. Always maintain documentation showing that eligibility requirements were met throughout the affected period.

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.

Strategic Timing to Reduce Tax Exposure

The timing of your C corp to S corp conversion can significantly affect tax liabilities. Converting when business assets are at lower market values can reduce potential built-in gains tax if those assets are sold later. Other strategic timing considerations include:

  • Scheduling the conversion before a projected period of slower growth or lower profits to minimize BIG tax exposure.
  • Aligning the election with fiscal year changes to simplify accounting and compliance.
  • Distributing excess cash or dividends before conversion to avoid E&P complications under S corp rules.

Evaluating both federal and state tax impacts before setting the effective date can help maximize post-conversion benefits.

Add After Heading: Tax Implications and Built-In Gains Tax Considerations

New Heading: Passive Investment Income Limits and E&P RulesContent:An S corporation that was formerly a C corporation must monitor its passive investment income closely. If passive income exceeds 25% of gross receipts for three consecutive years while the company still has C corp accumulated E&P, the IRS can revoke S corp status. Passive income includes:

  • Rents
  • Royalties
  • Dividends
  • Certain interest income

To avoid issues, businesses may need to reduce passive income streams, distribute excess E&P, or restructure operations. These measures can safeguard S corp status and prevent unexpected tax liabilities.

Tax Implications and Built-In Gains Tax Considerations

While S corporations enjoy pass-through taxation, certain tax liabilities must be considered when transitioning from a C corp. One major concern is the built-in gains tax (BIG tax), which applies to assets appreciated while the company was a C corporation. Key points include:

  • The built-in gains tax applies for five years after the transition if the corporation sells an appreciated asset that was held as a C corporation.
  • The tax is imposed at a flat rate of 21%, which corresponds to the corporate tax rate.
  • Businesses with low-basis assets, large inventories, or significant accounts receivable should conduct a thorough tax analysis before making the switch.
  • Strategies such as deferring asset sales or managing taxable events strategically can minimize exposure to the built-in gains tax.

Additionally, companies with significant accumulated earnings and profits (E&P) from their time as a C corp may face additional tax reporting requirements. If passive income exceeds 25% of gross receipts for three consecutive years, the IRS may revoke S corp status.

Avoiding BIG Tax Triggers Through Smart Planning

The Built-In Gains (BIG) tax is one of the most significant risks when converting from a C corp to an S corp. To avoid unnecessary BIG tax exposure:

  • Hold appreciated assets for at least five years after conversion before selling.
  • Distribute cash reserves or retained earnings before conversion to minimize E&P complications.
  • Avoid unnecessary revaluations or write-ups that could inflate built-in gain.
  • Consider tax-free reorganizations or asset restructuring before the election to isolate appreciated assets.

If asset sales are unavoidable, coordinate with a tax professional to offset gains with losses or defer recognition through installment methods.

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 the Transition Impacts Shareholder Taxes

The tax consequences of switching from a C corp to an S corp also impact shareholders, especially those with substantial ownership stakes. Key considerations include:

  • Dividend Taxation Differences: C corp dividends are taxed at capital gains rates (typically 15-20%), while S corp distributions avoid dividend taxation since profits pass through to owners.
  • Self-Employment Taxes: Unlike a C corporation, where shareholders working in the company are classified as employees, S corp shareholders must take a reasonable salary before receiving additional profit distributions. These distributions are not subject to self-employment taxes.
  • Loss Deductibility: Shareholders in an S corp can deduct business losses on their personal tax returns, which can be advantageous for businesses experiencing operating losses.

For businesses with multiple shareholders, restructuring ownership percentages and compensation strategies may be necessary before converting to S corp status.

Effect on Shareholder Basis and Distributions

When a C corp converts to an S corp, each shareholder’s stock basis becomes critical for determining taxation on distributions. Key points include:

  • Initial basis is calculated from each shareholder’s investment and retained earnings at the time of conversion.
  • Annual adjustments increase basis for pass-through income and decrease it for distributions or losses.
  • Distributions post-conversion are generally tax-free to the extent of basis but taxable once basis reaches zero.
  • Previously taxed earnings from C corp years remain subject to double taxation if distributed after conversion.

Tracking basis accurately prevents unexpected taxable distributions and ensures compliance with IRS reporting requirements.

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.

Common Mistakes to Avoid When Switching to an S Corporation

Failing to follow proper procedures when converting from a C corp to an S corp can lead to IRS rejection or unexpected tax consequences. Common mistakes include:

  • Missing the filing deadline: Businesses that fail to submit Form 2553 on time risk remaining a C corp for another year, potentially facing higher tax liabilities.
  • Violating the shareholder restrictions: If the company has ineligible shareholders (such as partnerships or foreign individuals), the IRS will deny S corp status.
  • Maintaining multiple classes of stock: S corps are only allowed one class of stock. Any special allocations, preferred stock, or voting/non-voting distinctions can trigger a violation.
  • Failing to manage retained earnings properly: If a former C corp has retained earnings subject to accumulated earnings tax, it may need to make distributions before the transition to avoid penalties.
  • Not accounting for the built-in gains tax: Selling highly appreciated assets soon after converting can lead to unexpected tax bills under the BIG tax rules.

Working with a tax professional or attorney is recommended to ensure all compliance issues are addressed before making the switch.

Operational and Administrative Oversights

Administrative errors can jeopardize S corp status or lead to costly IRS penalties. Common pitfalls include:

  • Improper shareholder agreements that unintentionally create a second class of stock.
  • Failure to update bylaws and minutes reflecting the S corp election.
  • Overlooking payroll compliance—officer compensation must meet “reasonable salary” standards.
  • Mixing business and personal funds, which risks piercing the corporate veil.

Establish internal compliance protocols and schedule periodic reviews to confirm ongoing adherence to S corp requirements.

State-Level Compliance Pitfalls

While the IRS governs federal S corp status, state rules can vary widely. Common state-level mistakes include:

  • Failing to file separate state S corp elections – Some states, such as New York and New Jersey, require their own forms.
  • Overlooking franchise or excise taxes – Even with S corp status, states like California and Texas impose minimum franchise taxes.
  • Not accounting for non-conforming states – A few states do not recognize S corp status, which can result in hybrid federal/state taxation.

Ensuring compliance with both federal and state requirements before conversion can prevent costly penalties and maintain the intended tax advantages.

Frequently Asked Questions

  1. How long does it take to convert a C corp to an S corp?
    Typically, the IRS processes Form 2553 within 60 days. If filed on time and without errors, your S corp status is effective at the start of the tax year.
  2. What happens if I miss the election deadline?
    You may request late election relief under IRS Revenue Procedure 2013-30 by demonstrating reasonable cause and filing consistent returns.
  3. Can an S corp revert to C corp status?
    Yes. Corporations can revoke S corp status voluntarily by filing a written statement with the IRS, typically effective at the start of the next tax year.
  4. How does the built-in gains tax period work?
    The BIG tax applies to appreciated assets sold within five years after conversion. After that period, asset sales are no longer subject to BIG tax.
  5. Do all states recognize S corp status?
    No. Some states (e.g., New York, New Jersey, and California) require separate elections or impose franchise taxes even after S corp conversion.

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