1. Converting a C Corporation to an S Corporation
2. Tax Inefficiency of a C Corporation
3. How to Elect S Corp Status

Convert C corp to S corp is a move that many owners of corporations consider making in order to gain a tax advantage. 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.

Converting a C Corporation to an S Corporation

The main reason corporations elect S corp status is to allow their taxable incomes to pass through to the personal tax returns of their shareholders so that they will be taxed at lower rates. One of the main disadvantages of a C corporation is that it is subject to double taxation. While it can pay more compensation to its shareholder-employees and use other ways to reduce taxes on its corporate income, all methods have their limitations.

One effective method is to convert to an S corp, which enables the corporation to avoid double taxation without having to liquidate the company. However, this may not be a suitable solution for all kinds of corporations because of restrictions on corporate structure, number and types of shareholders allowed, and classes of stock. Switching from a C corp to a limited liability company (LLC) is another way to get rid of double taxation. Nonetheless, for federal tax purposes, this method requires the liquidation of the corporation, which can lead to tax liability at both the corporate level and shareholder level.

Tax Inefficiency of a C Corporation

A C corporation's income is taxed at a federal rate of up to 35 percent. The dividends that are distributed to individual shareholders are then subject to a 15 percent federal tax. These dividends cannot be written off by the corporation. Therefore, a C corporation is required to pay taxes on its distributed earnings at a total federal tax rate of 44.75 percent.

If a corporation elects S corp status or a non-corporate business structure such as partnership or LLC, it will only have to pay taxes once at the owner level. Even if the owners are subject to the highest individual tax rate, there will be a savings of 9.75 percent of taxable income.

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.

If you need help with converting your corporation to an S corporation, 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.