Switching Entities: Should You Convert from a C to an S Corporation?
- Learn about the pros and cons of converting from a C to an S corporation.
- Find out how LIFO inventories can affect your entity conversion.
- Learn how (and for how long) built-in gains from your C corporation may affect taxes on your S corporation.
- Find out how to deal with taxes associated with passive investment income for an S corporation that was formerly a C corporation.
- Discover the treatment of unused losses from a C corporation when you convert to an S corporation.
The best choice of entity can affect your business in several ways, including the amount of your tax bill. In some cases, businesses decide to switch from one entity type to another. Although S corporations can provide substantial tax benefits over C corporations in some circumstances, potentially costly tax issues exist that you should assess before making the decision to convert from a C corporation to an S corporation. And what are those issues, you ask? Read on for Fiducial’s list of things to consider when thinking about an entity conversion.
1. LIFO inventories and C corporations
C corporations that use last-in, first-out (LIFO) inventories must pay tax on the benefits they derived by using LIFO if they convert to S corporations. You may spread the tax over four years. However, you must weigh this cost against the potential tax gains from converting to S status.
2. Built-in gains tax
Although S corporations generally aren’t subject to tax, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) that the C corporation has when the S election becomes effective, if those gains are recognized within five years after the conversion. This is generally unfavorable. However, situations exist where the S election still can produce a better tax result despite the built-in gains tax.
3. Passive income
S corporations that were formerly C corporations are subject to a special tax. It kicks in if their passive investment income (including dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If that tax is owed for three consecutive years, the corporation’s election to be an S corporation terminates. You can avoid the tax by distributing the accumulated earnings and profits, which would be taxable to shareholders. Or you might want to avoid the tax by limiting the amount of passive income.
4. Unused losses for C corporations
If your C corporation has unused net operating losses, they can’t be used to offset its income as an S corporation and can’t be passed through to shareholders. If you can’t carry the losses back to an earlier C corporation year, you will need to weigh the cost of giving up the losses against the tax savings you expect to generate by the switch to S status.
Other considerations
We have only listed some of the factors to consider when switching a business from C to S status. For example, shareholder-employees of S corporations can’t get all of the tax-free fringe benefits available with a C corporation. Shareholders who have outstanding loans from their qualified plans may also have issues. You must take these factors into account in order to understand the implications of converting from C to S status.
Interested in an entity conversion? We can explain your options, how they’ll affect your tax bill, and some possible strategies you can use to minimize taxes. Call Fiducial at 1-866-FIDUCIAL or make an appointment at one of our office locations.
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