Converting from C Corporation to S Corporation

The principal advantage of electing S status is that it allows corporate income to pass through to shareholders, who report it only once as personal income. This avoids the double taxation that occurs on C corporation earnings, which are taxed once as corporate profits, and then again as personal income when dividends are distributed to shareholders.

Several pieces of legislation have mitigated at least some of the of double taxation burden of a C corporation. These laws provide that dividends received by an individual shareholder from domestic corporations (and qualified foreign corporations) are taxed at lower long-term capital gains tax rates. Most recently, in general, the American Taxpayer Relief Act of 2012 permanently extended the preferential income tax treatment of qualified dividends and capital gains. Capital gains and qualified dividends are generally taxed at 0% for taxpayers in the 10% and 15% tax brackets, and at 15% for taxpayers in the 25% to 35% tax brackets. However, starting in 2013, dividends and capital gains are generally taxed at 20% for taxpayers in the new 39.6% tax bracket for high-income taxpayers. Also, as a result of the Affordable Care Act of 2010, beginning in 2013, an additional 3.8% Medicare tax applies to some or all of the investment income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

Selection Requires the Following Conditions

A C corporation may elect S status if the following conditions are met:

• It must be incorporated in the United States
• It must have no more than 100 shareholders (if elected, all members of a family will be treated as one shareholder)
• Shareholders must be U.S. citizens, resident aliens, estates, other S corporations, or certain qualified trusts
• It must have only one class of stock, although both voting and nonvoting shares of the same class are allowed
• All shareholders must consent to the election in writing

When Can It be Used?

To Avoid Double Taxation of Corporate Earnings: You may want to consider electing S status if the corporation is earning profits and shareholders want to avoid double taxation on the earnings.

To Offset Personal Income with Corporate Losses: S corporation status also allows you to deduct the corporation’s losses up to certain limits against your own personal income. Because losses are common in a business’s start-up phase, new enterprises often elect S status for the early years.

Strengths

The advantages of an S election depend on the tax situation of both the corporation and its shareholders.

S Corporations Avoid Double Taxation of Earnings: A major advantage of an S corporation is that its earnings are not subject to the double taxation that applies to C corporation earnings. S corporation earnings are taxed only once as income to shareholders.

Example: ABC, Inc., an S corporation, passes through earnings to its two shareholders, Ken and Bob, who pay taxes on the earnings based upon their marginal income tax rates. Ken and Bob both pay tax at a marginal income tax rate of 35 percent.

XYZ, Inc., a C corporation, pays corporate income tax at the rate of 34 percent. Frank and Jeff are the sole shareholders in XYZ, Inc. Dividends paid by XYZ are taxed at the rates that apply to capital gains. For Frank and Jeff, this means that the dividends they receive from XYZ are subject to federal income tax at the rate of 15 percent.

Both ABC, Inc. and XYZ, Inc. have net earnings of $100,000.

S Corporation Losses can be Deducted Against Personal Income:
S corporation losses pass through to shareholders (subject to certain limitations), who can use them to offset personal income. Losses of a C corporation offset corporate income but don’t pass through to shareholders.

Tradeoffs

S Corporations Can Offer Only a Limited Range of Tax-Deductible Fringe Benefits: S corporations are limited in the range of tax-deductible fringe benefits they can offer. Since many new businesses can’t afford fringe benefits, this only makes a difference to mature, profitable companies that can offer them and thus take advantage of the tax deduction to offset profits.

Other Conversion Consequences: Converting from an existing C corporation to an S corporation may result in the following situations:

• Favorable tax attributes, such as loss carryforwards, may be lost
• Problems may be created with pension and profit-sharing plans
• Some appreciated assets may not escape double taxation
• Prior losses incurred by foreign branches may be reversed and included in income
• Cash-basis C corporations may be subject to double tax on their uncollected receivables as they are collected after the S election

The tax rules related to these situations are complicated and beyond the scope of this discussion. For further information, consult additional sources.

How To Do It

File in a Timely Manner: If you wish to convert from a C corporation to an S corporation, you must file within 2 months and 15 days of the start of the corporation’s tax year. If you miss this deadline, you must wait until the following year to file.

Follow These Steps: Converting from a C corporation to an S corporation is not difficult to accomplish.

• File Form 2553, Election by Small Business Corporation, with the IRS. To obtain a copy of the form, call the IRS at (800) 829-FORM, drop into your nearest tax office, or contact your tax professional. Or you can get the form on the Internet at the IRS website at www.irs.ustreas.gov.
• Have the form completed and signed by the person authorized to sign the corporation’s tax returns, usually the president or a corporate officer.
• Have all shareholders sign the form; otherwise, the S election is invalid.
• Mail the completed form to the IRS Service Center where you file your individual tax returns. Include an extra copy with a self-addressed stamped envelope. Request the IRS to stamp the copy with the date received and return it to you. Or, hand-carry the form to the nearest IRS office and get it stamped for your records. The IRS usually won’t copy the form for you, so mail or bring your own copy for stamping.

Once a corporation elects S status, it retains that status for all future years unless it is revoked or terminated.

Tax Considerations: Before making the S election, accumulated earnings and profits should be distributed to avoid double taxation in the future.

Conversion May Give Rise to Taxable Income: Tax complications may arise upon conversion. A converted S corporation will have taxable income if it had passive income, if it used the last in, first out inventory method of accounting, or if it holds assets with built-in gain attributable to the depreciation of the assets prior to the S election. Consult a tax professional to ensure the conversion will not result in unforeseen and undesirable tax consequences.

If you have questions, contact the Experts at Henssler Financial:

• Experts Request Form
• Email: experts@henssler.com
• Phone: 770-429-9166.