Tax Issues When Converting from a C Corporation to an S Corporation

Your small business may be considering a conversion from its C Corporation entity structure to become an S Corporation. There are many tax benefits to making an S Corp election, but there are also some tax pitfalls to be aware of. Here are some important issues to consider:

Built-in Gains Tax

If an S Corporation was previously a C Corporation, built-in gains held by the C Corporation are taxable if those gains are recognized within five years after the conversion to an S Corporation. Even so, there may be situations where the S election can still produce a better tax result even with the built-in gains tax.

Passive Income

There’s a special tax if the passive investment income of the converted S Corporation (dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of gross receipts and the S Corporation has accumulated earnings and profits carried over from the C Corporation. If that tax is owed for three consecutive years, the corporation’s S election terminates. The S Corporation can avoid this tax by distributing accumulated earnings and profits, resulting in taxable income to shareholders. Alternatively, the tax can be avoided by limiting the amount of passive income or generating an overall taxable loss.

LIFO Inventories

If the converting C Corporation used LIFO inventories, tax is owed on the benefit derived from using LIFO. This tax can be spread over four years.

Unused Losses

Unused net operating losses held by the C Corporation cannot be used to offset S Corporation income, nor can it be passed along to shareholders. If the losses can’t be carried back to an earlier C Corporation year, the cost of giving up those losses needs to be considered against the tax savings expected from the S Corporation election.

Other Factors

Shareholders of an S Corporation are not allowed to participate in the same nontaxable fringe benefits as C Corporation owners. For instance, 2% owners in an S Corporation cannot participate in a company’s Section 125 cafeteria plan or Health Savings Account. Also, any outstanding loans from the company’s qualified retirement plan may need to be reviewed.

Depending on your organization’s situation, you might be able to take advantage of strategies to eliminate or minimize the adverse tax consequences from converting from a C to an S Corporation. Contact us for more guidance.