C Corp To S Corp Conversion: Everything You Need to Know
The C corp to S corp conversion is a strategy that changes the tax structure of a C corporation to that of a pass-through entity. 3 min read
2. Requirements for Converting C to S Corporation Status
3. Tips for Converting from C Corporation to S Corporation Status
Updated July 16, 2020:
The C corp to S corp conversion is a strategy that changes the tax structure of a C corporation to that of a pass-through entity. This results in the income as well as any deductions, losses, credit, and gains being passed through to the owners who are responsible for the taxes and not the business.
Converting from C Corporation to S Corporation Status
The easiest and most cost-effective method to change the status of a C corporation is by converting to an S corporation. Although a viable option, an S corporation has limitations and may not work for every type of business.
The downside to electing to convert a C corporation to an S corporation is the S structure may not be the best alternative for a business or its shareholders. If the requirements of an S corporation are not in sync with the business model, another option to the business structure may be necessary. If this is the case, a C corporation can convert to a limited liability company (LLC) instead of an S corporation.
Before switching from a C corporation to an S corporation it is recommended that owners consider the impact it can have on the appraised fair market value (FMV) of the business if there are plans for it to become a gift or part of an estate. If an owner plans to gift or bequest any part of or all of their stock in the corporation, when changing from C to S corporation status it can increase the fair market value by as much as 50 percent or more.
Requirements for Converting C to S Corporation Status
To meet the obligations of the Internal Revenue Service for tax purposes, filling out and filing Form 2553 is the only requirement to make the conversion to S corporation status.
Not every C corporation is eligible to convert to S corporation status. There are requirements that must be met involving shareholders, accumulated earnings, profits, and passive income, as well as capitalization corporate requirements.
The requirements only apply to domestic corporations that are not:
- Financial institutions that are handling the accounting for bad debts using Sec. 585 reserve method.
- Insurance companies that are taxable under subchapter L.
- Domestic International Sales Corporations (DISCS) or former DISCS can qualify for S corporation status.
There are limitations to S corporations in regard to shareholders. As an S corporation, 100 shareholders is the maximum. The only eligible individuals who can participate as shareholders in an S corporation are U.S. citizens or residents. Certain trusts, estates, and tax-exempt organizations can be shareholders in an S corporation.
Only corporations with one class of stock are eligible to convert to S corporation status. One class stock may become problematic and limited if there are special allocations involving certain shareholders regarding corporate earnings. Another potential problem involves financing arrangements that consider equity-based payments or options to buy shares.
Earnings, Profits, and Passive Income
If the S corporation has excessive amounts of passive income and income and profit accumulated as a C corporation, there is the potential for an S corporation to be subject to taxes at the corporate level and have its S status terminated. A possible way to avoid these two situations is by distributing the profits and earnings to the shareholder.
Tips for Converting from C Corporation to S Corporation Status
- If you have any plans of "gifting" your stock, do so before electing S corporation status.
- To avoid understatement penalties, get an appraisal. This way, you have done your part to get an accurate appraised figure and it will be up to the IRS to prove otherwise. Select an expert in the field who can value the corporation from both sides. Be aware that a judge has the discretion to reject or challenge the valuation calculation.
- Determine if the laws in your state permit the conversion of a domestic stock corporation to another entity structure that will be recognized in the state.
- Once the election is made, file Form 1120S for the tax year the election is made.
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