How to Convert S Corp to C Corp: Process, Taxes, and Benefits

Key Takeaways

• Converting from an S Corp to a C Corp requires a formal revocation of S Corp status filed with the IRS, with majority shareholder consent.
• Common reasons for conversion include attracting more investors, issuing multiple classes of stock, or benefiting from corporate tax rates.
• Tax consequences include potential double taxation, loss of pass-through taxation, and built-in gains tax if appreciated assets are sold within five years.
• Timing the conversion strategically can reduce tax impacts, such as distributing accumulated earnings before the switch.
• C Corps offer advantages like unlimited shareholders, greater investment opportunities, and expanded fringe benefits.

To convert S Corp to C Corp, an S Corporation can simply officially cancel its Subchapter S status election with the consent of the majority of its shareholders. On the other hand, unanimous consent will be required to reelect Subchapter S status later. It can be a long-term decision, so make sure you really want to convert before you begin the proceedings.

How to Convert From S Corp to C Corp

You can voluntarily change from an S Corp to a C Corp anytime you wish. If you want the change to take effect on the first day of your corporation's taxable year, you must revoke your S Corp election by the 15th day of the third month of that tax year. Once your shareholders agree to the change, it's a relatively quick process to convert. It typically takes less than a month to finalize everything.

The IRS doesn't have a standard form to complete to change your company's tax status. You'll take the following steps to convert to a C Corp:

1. File a “Revocation of S Corporation Status” document: You'll file this with the IRS Service Center where you filed for S-election. In the document, you'll provide information on the corporation name, the tax ID number, and the number of outstanding shares.
2. Complete and sign the document: The statement should be completed and signed by whoever is authorized to sign your corporate tax returns; this is normally the president or one of the corporate officers.
3. Include a statement of consent: This should be signed by any shareholders who own more than 50 percent stock in the company. This includes nonvoting shares.

Make a copy of any paperwork for your own records, and store them with your tax documents.

Before you make any changes to your business's tax status, you might want to consult with a tax professional since they can provide expert advice.

Preparing for the Transition

Before proceeding with the revocation of S Corp status, business owners should conduct a thorough assessment of their company’s financial and operational goals. Key preparatory steps include:

• Consulting a Tax Professional: Understanding tax consequences, including potential double taxation, is essential.
• Evaluating Financial Impact: Determine how corporate tax rates will compare to pass-through taxation.
• Assessing Shareholder Intentions: Ensure shareholders understand the shift in taxation and ownership structure.
• Timing the Conversion: If a transition is planned, consider when to implement it for optimal tax benefits.

Evaluating Strategic Reasons for Conversion

Beyond meeting compliance requirements, it’s important to assess whether converting from an S Corp to a C Corp aligns with your company’s long-term goals. Common strategic reasons include:

• Raising Capital More Easily: C Corps can issue multiple classes of stock and have unlimited shareholders, making them attractive to venture capitalists and institutional investors.
• Preparing for an IPO: Public offerings require a C Corp structure, so businesses planning to go public often convert in advance.
• Retaining Profits for Growth: Unlike S Corps, where income is passed through to shareholders annually, C Corps can retain earnings for reinvestment without immediate shareholder taxation.
• Expanding Ownership Base: C Corps can have foreign shareholders, corporations, and other entities as owners, which S Corps cannot.

Requirements to Maintain S Corporation Status

Business owners may choose to change their tax status if their companies no longer meet the requirements to be an S Corp, as outlined by the IRS. You must give all shareholders adequate notice of your intention to change. They must be given the opportunity to attend a meeting to consent to the change.

To continue as an S Corp, you must meet all of the IRS criteria:

• You cannot have more than 100 shareholders.
• Your shareholders cannot be non-resident aliens.
• Your shareholders cannot be other companies, LLCs, S Corporations, etc.
• You cannot issue more than one class of stock.
• You must have the approval of all shareholders to become an S Corporation.
• You must file an IRS Form 2553 within a specific time frame.

If the IRS discovers that your business doesn't qualify for S Corporation status, they will immediately terminate your election. This can result in negative tax consequences. If you fail to meet any of the requirements, you'll have to convert your business's tax status.

One reason you might need to change is if you wish to increase the number of shareholders. You might want to bring in foreign investors or obtain additional funding, for example. If you would like your business to increase income without your shareholders being taxed on their part of retained income, you might consider changing your tax status. The tax rate for C Corp profits is lower for shareholders who are in high tax brackets. These owners benefit from C Corp status because they'll have a lower tax rate for cooperative earnings. This reduction in tax rate also reduces cash flow for the corporation. In other cases, the IRS can end a company's S Corp tax status if the business violates any of the above requirements.

S Corp to C Corp Conversion Tax Consequences

You might want to think about the following tax considerations before converting:

• When you convert from an S Corp to a C Corp, there will be no immediate gain or loss.
• A corporation has a limited amount of time to distribute earnings to shareholders when it converts from S Corp to C Corp. Once that time frame is up, those distributions are taxed as dividends.
• If you convert midyear, your corporation will have to file two returns for that year.
• When you terminate an S Corp, you won't be able to elect for S Corp status again for five years, unless you get approval from the IRS.

While it's not especially time-consuming to change your company's tax status, before making the switch from S Corp to C Corp, tax considerations should definitely be considered. In some cases, you're legally required to make the change. It never hurts to get advice from a trusted tax professional, as well as an attorney well-versed in these matters. You can talk to an UpCounsel's lawyer posting a job for free.

Special Tax Opportunities for C Corporations

In some cases, switching to C Corp status can open access to unique tax benefits, such as:

• Section 1202 Qualified Small Business Stock (QSBS) Exclusion: Shareholders of eligible C Corps may exclude up to 100% of the gain on the sale of qualified stock if it’s held for at least five years. This benefit does not apply to S Corps.
• Potential Rate Advantages: While C Corps face double taxation, the flat 21% corporate tax rate may be lower than high individual rates for certain owners.
• Expanded Deduction Options: C Corps can deduct a broader range of fringe benefits, such as health insurance and retirement contributions, without triggering shareholder-level taxation.

Tax Planning Strategies for a Smooth Transition

To minimize the tax burden when converting an S Corp to a C Corp, businesses can implement proactive tax planning measures:

1. Distribute Accumulated Earnings Before Conversion: If the S Corporation has retained earnings, consider distributing them before conversion to avoid potential double taxation on future distributions.
2. Utilize the Built-In Gains Tax Window: The IRS imposes a built-in gains (BIG) tax on S Corps that convert to C Corps and sell appreciated assets within five years. Proper planning can help mitigate this risk.
3. Consider Compensation Adjustments: C Corps can deduct salaries, but dividends are not deductible. Adjusting shareholder compensation before the transition may help offset tax impacts.
4. Leverage Tax Credits and Deductions: A C Corp structure allows for different deductions, including expanded fringe benefits and retirement plan contributions.

Limits of S Corporation

For an S Corporation to be legally valid, it cannot have the following:

• Over 100 shareholders
• Ineligible shareholders
• Multiple classes of stock (however, it's permitted to have both nonvoting and voting stock)

Revoking an S Corporation

Revoking an S Corporation election becomes necessary when the S Corporation no longer meets legal S Corporation requirements. Before an S Corporation's status can be revoked, however, the corporation has to pass a shareholders' resolution to create the necessary authorization to officially cancel its S election. There's no formal IRS form that needs to be filed to revoke an S Corporation status. Instead, a written statement should be filed with the appropriate IRS service center. The statement has to clearly state that the corporation has resolved to cancel its S Corporation election.

That has to be done with the consent of shareholders with over 50 percent of the issued and unpaid shares of stock, nonvoting stock inclusive. Each shareholder who gives consent must sign the resolution in the presence of a notary public as a witness. Once completed, the document should be submitted to the IRS.

Determining the Effective Date of the Revocation

Unless you specify an effective date in your revocation, which cannot be one that precedes the revocation statement filing date, your effective date will depend on when in the corporation's tax year the revocation was filed. Revocations filed on or before the 15th day of the third month in the current tax year will be effective for the current year. If your statement is filed later than that date, your revocation will take effect on the first day of the following tax year. When your revocation becomes effective, you will file your taxes for the following year utilizing IRS Form 1120 instead of Form 1120-S, which is the S Corporation tax form.

After Revoking an S Corporation

When an S Corporation's status is revoked, all subsidiaries of the S Corporation are also terminated. As a result, the former subsidiaries will be considered new corporations that can acquire their assets and liabilities from their former S Corporation, exchanging them for the new corporation's stock. As a general rule, gain won't be recognized on the exchange. However, taxpayers should know that there are some exceptions to the general rule. For instance, in a case where a former subsidiary's liabilities extend beyond its assets' tax basis, gain will occur and be recognized.

Reasons for S Corporation Revocation

A corporation's S status can be voluntarily revoked by its shareholders at any time or terminated by the IRS for contravening one or more requirements for eligibility. The following circumstances are some of the reasons shareholders may consider revoking the S status of their S Corporation:

• The corporation feels the need to increase its investor base.
• The corporation plans on going public.
• The corporation's profits have increased and it wants to counterbalance income with fringe benefits that are tax-deductible.

The violation of an S Corporation's eligibility requirement is often detected during tax returns audits. However, a relief provision that can permit the S election to continue without interruption, even in the event of a detected violation, was adopted by the IRS. But, in certain cases, if the IRS finds out that an S Corporation isn't qualified for S election, it will terminate the election automatically with undesirable tax consequences.

Benefits of a C Corporation

Though an S Corporation has several benefits, shareholders can decide to convert it to a C Corporation under certain circumstances for some advantages.

1. For instance, a C Corporation pays taxes at lower corporate rates on its profits. For its shareholders who are in high tax brackets, a C Corporation's cooperative income is allowed to be taxed at a lower rate of 15 percent on the most initial $50,000 of taxable revenue.
2. Structuring a company as a C Corporation makes it easier to raise capital than an S Corporation because a C Corporation's market of shares is potentially larger. That's because a C Corporation isn't restricted to a number of shareholders and classes of stock. A C Corporation also has the ability to target various classes of stock to diverse investors. For such reasons, venture capitalist and investors are attracted to C Corporations.
3. Another advantage of the C Corp is the fact that it can offer a greater number of tax-friendly fringe benefits than an S Corp.

Potential Drawbacks to Consider Before Converting

While C Corps provide numerous advantages, there are also possible downsides:

• Double Taxation Risk: Profits are taxed at the corporate level and again when distributed as dividends to shareholders.
• Loss of Pass-Through Loss Deductions: S Corp shareholders can use corporate losses to offset other income, but C Corp shareholders cannot.
• Built-In Gains Tax: If the corporation sells appreciated assets within five years of conversion, it may owe built-in gains tax.
• Complex Compliance Requirements: C Corps generally face more rigorous reporting and regulatory obligations.

Key Differences Between S Corp and C Corp

Understanding the fundamental differences between an S Corp and a C Corp is crucial when making the transition. Some key distinctions include:

By understanding these differences, business owners can make an informed decision about whether a C Corp structure aligns with their long-term growth strategy.

Frequently Asked Questions

1. Can I convert from S Corp to C Corp in the middle of the year?
   Yes, but you’ll need to file two separate tax returns for that year—one for the S Corp period and one for the C Corp period.
2. How can I minimize taxes when converting?
   Plan ahead by distributing accumulated earnings before conversion and evaluating whether to defer asset sales to avoid built-in gains tax.
3. What is the Section 1202 exclusion, and does it apply after conversion?
   Section 1202 allows qualifying C Corp shareholders to exclude significant capital gains on stock sales if specific requirements are met, but eligibility starts after the conversion date.
4. Will I lose the ability to pass through losses after converting?
   Yes. C Corps cannot pass corporate losses to shareholders for individual tax purposes.
5. Do I need shareholder approval to convert?
   Yes, consent from shareholders owning more than 50% of the company’s stock (including non-voting shares) is required.

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