Updated July 14, 2020:

Some corporations elect to change from a C corp to an S corp to access the tax benefits of an S corporation, such as avoiding double taxation. Your C corporation must meet the following requirements to be treated as an S corp for tax purposes by the IRS:

  • Be a domestic corporation
  • Not be a financial institution accounting for bad debts under Section 585
  • Not be a Subchapter L insurance company
  • Not be a possessions corporation
  • Not be a current or former DISC
  • Not have more than 100 shareholders
  • Be owned solely by U.S. citizens or residents, certain types of trusts and estates, and certain types of tax-exempt organizations
  • Have written agreement from all shareholders

In addition, S corporations can only offer one class of stock. However, this class can have different voting rights among shareholders. This rule is a problem if the corporation wants to provide preferred returns on shares for certain shareholders. A corporation is only considered to have one class of stock if every share carries identical liquidation proceeds and distribution rights. This means that standard transactions such as leases and compensation arrangements can violate this guideline.

Having only one class of stock may also be an issue if the corporation offers options to buy shares or equity-based payments. If your corporation falls into any of these categories, S corporation election may not be the best choice for your business.

How to Convert a C Corp to an S Corp

You must file your S corporation election within two months and 15 days of the start of your business tax year. If this deadline passes, you cannot change your election until the following year. When you elect S corp tax status, you keep this status until it is terminated or revoked.

This conversion requires IRS Form 2553, Election by Small Business Corporation. You can obtain a copy online, get it from your accountant, stop by your local IRS office, or call the IRS at 800-829-FORM to request a mailed copy.

After filing Form 2553, you must complete Form 1120 for the tax year when you elected S corp status. This should be filled out and signed by the same person who has authorization to complete your firm's tax returns. All shareholders must sign both forms to validate S corp election.

Both forms can be submitted online, mailed to your IRS Service Center, or delivered to your local IRS office. Include an extra copy and a self-addressed stamp envelope so the IRS will send you a stamped copy of the completed form.

Tax Considerations

Although electing S corp status carries tax benefits, some complications can also occur. Your corporate income may still be taxed if it included passive income; was accounted for using the last in, first out method; or held assets with built-in gain before S election. You should consult a tax professional before electing S corp status to make sure doing so doesn't have unfavorable financial consequences.

For example, you may lose loss carryforwards and other C corporation tax benefits; cause issues with profit-sharing and pension plans; and owe double taxation on unappreciated assets, prior losses, and uncollected receivables. Consider distributing all profits and accumulated earnings before electing S corp status to avoid double taxation on these funds.

For most businesses, however, C corporation status is not beneficial for taxation purposes. C corps are subject to a federal income tax rate of up to 35 percent. When profits are distributed to shareholders, they are taxed again at 15 percent, subjecting shareholders to double taxation and disallowing the corporation from taking these dividends as deductions.

In contrast, S corporations are subject to pass-through taxation, in which profits and losses are reported on each shareholder's individual income tax return. These earnings are not subject to the high corporate tax rate and can provide even more savings on state taxes.

Lowering Taxable Income

Many C corporations opt to minimize their tax burden by lowering their taxable income. They do so by compensating shareholder-employees with salaries, which are tax-deductible, instead of dividends, which are not. Although this approach can alleviate double taxation, its scope to do so is limited.

If you need help with deciding between C corp and S corp taxation, you can post your legal need on UpCounsel's marketplace. Upcounsel accepts only the top 5 percent of lawyers to its site. Lawyers on UpCounsel come from law schools such as Harvard Law and Yale Law and average 14 years of legal experience, including work with or on behalf of companies like Google, Menlo Ventures, and Airbnb.