S-corp conversion is the process of electing S corporation tax treatment for a standard C corporation or limited liability company (LLC). Before making this election, it's important to understand the tax implications and other issues that may affect your business.

Tax Implications of S-Corp Conversion

While S-corp conversion can result in substantial tax savings for qualifying business owners, it's important to consider potential costs also. For example, a C-corp that converts to an S-corp is subject to built-in gains tax of 35 percent on appreciated property that is sold within five years of the first day of the first year in which S-corp conversion is affected. When an S-corp sells an appreciated asset, it must determine the unrealized appreciation present at the time of S-corp election by comparing the fair market value at the election date to the tax basis.

This calculation must be done separately for each appreciated asset. The net amount of unrealized gains and losses is considered the built-in gain of the S-corp. A prorated portion of the taxed amount must be reported on each shareholder's Schedule K-1. Assets sold after the fifth year after S-corp election are not subject to the built-in gains tax. Many new S corporations choose to operate at a loss for the first five years to avoid this tax.

C corporations that convert to S corporations are also taxed if passive income exceeds 25 percent of gross receipts and the corporation has carried over profits and earnings from its days as a C corporation. Passive income includes:

  • Interest
  • Dividends
  • Royalties
  • Rent
  • Stock sale gains

Many new S-corps avoid this tax by distributing profits and earnings as taxable shareholder income rather than accumulating them. Corporations that owe this tax for three years in a row are no longer eligible for S-corp status.

C corporations with unused net operating losses cannot use these losses to offset S-corp income or pass them through to shareholders. These losses must be credited to an earlier C-corp year or forfeited; however, they can be reinstated if the S-corp ever converts back to a C-corp.

Newly converted S-corps are also charged income tax on profits that were not taxed before the election. This commonly affects accounts receivable that were not collected and/or real estate that has appreciated.

If a C-corp uses LIFO inventories, it is taxed on these derived benefits when converting to an S-corp. This tax can be paid in equal payments over four years.

If you're considering an S corporation conversion, an attorney can help you determine which of these taxes will affect you and whether it is financially advantageous to make the S election.

Requirements of S-Corp Status

Converting a C corporation to S-corp status makes it a pass-through entity in which income is not taxed at the corporate level. Instead, profits and losses pass through to the shareholders, who are taxed at the individual rate. This allows the business to avoid the double taxation that affects C corporations.

However, the corporation must meet certain requirements to be eligible for S election. This status is available only to domestic corporations that are not financial institutions, insurance companies, possessions corporations, or current or former DISCs. An S-corp must have fewer than 100 shareholders, all of whom must be U.S. citizens or residents, certain trusts and estates, and certain tax-exempt organizations.

S corporations must offer only one class of stock, though different voting rights can be offered within this class. This can be a limitation for C corps that have shareholders who want a preferred return on their investment, as well as for those who offer equity-based payments and other financing arrangements.

Advice for Making the Conversion

Preparation can help you minimize your corporation's tax burden. To derive maximum benefit from S-corp election, C corporations should:

  • Gift stock before making the election.
  • Have an appraisal, which shifts the burden of proof for understatement penalties to the IRS.
  • Choose valuation experts carefully.
  • Understand that judges can challenge every valuation estimate.

If you need help with converting your C 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, Stripe, and Twilio.