Key Takeaways

  • The deadline to switch from C corp to S corp is no later than two months and 15 days after the beginning of the tax year in which the election is intended.
  • Converting from a C corporation to an S corporation requires filing Form 2553 with the IRS and ensuring all shareholders meet eligibility requirements.
  • S corporations offer pass-through taxation, avoiding double taxation, but they come with restrictions such as a 100-shareholder limit and a requirement to have only one class of stock.
  • Tax implications include built-in gains tax, which applies to appreciated assets when sold within five years after conversion.
  • The advantages of electing S corp status include reduced tax liability on distributions and avoidance of double taxation, while disadvantages include limitations on stock structure and shareholder eligibility.
  • Businesses with substantial retained earnings may face tax consequences when converting, especially if they have large cash reserves or investments in passive income assets.
  • Professional legal and tax guidance is recommended before making the switch to avoid unexpected tax liabilities.

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.

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.

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.

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.

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.

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.

Frequently Asked Questions

  1. What is the deadline to switch from a C corp to an S corp?
    The deadline to file Form 2553 is two months and 15 days after the start of the tax year for the election to take effect that year. Late election relief may be available under specific conditions.
  2. Can an S corp have foreign shareholders?
    No, S corps cannot have foreign shareholders. Only U.S. citizens, resident aliens, and specific trusts or estates can hold shares.
  3. Does converting to an S corp save money on taxes?
    It depends on the business structure. S corps avoid double taxation, but they also lose access to some C corp tax benefits, such as lower corporate tax rates on the first $100,000 of income.
  4. What happens if my business violates S corp requirements after conversion?
    If a business violates eligibility rules (e.g., exceeding the 100-shareholder limit or issuing multiple classes of stock), the IRS can revoke S corp status and revert the business to C corp taxation.
  5. How do I know if switching to an S corp is the right decision for my business?
    The decision depends on factors like profit levels, shareholder structure, and future growth plans. Consulting with a tax expert or legal advisor can help determine whether an S corp election aligns with your business goals.

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