Converting from S Corporation to C Corporation

Shareholders can voluntarily revoke the S election at any time, or the IRS can terminate it for violation of one or more of the eligibility requirements.

When Can It Be Used?

Voluntary Revocation: Shareholders may wish to revoke the S election and convert to a C corporation in the following circumstances:

• The corporation wants to broaden the investor base or go public in the near future. A C corporation offers greater potential for broadening the investor base and raising capital.
• The corporation has become profitable and wants to offset income with tax-deductible fringe benefits. C corporation status allows the business to offer a broader range of tax-deductible fringe benefits.

Termination by Law: The IRS can terminate the S election, causing it to automatically revert to a C corporation, in the following circumstances:

• The corporation fails to meet the eligibility requirements of an S corporation. Likely violations include having more than 100 shareholders, having one or more ineligible shareholders, or having more than one class of stock. Terminations are generally effective on the date of the termination event.
• The corporation has accumulated earnings, profits, and passive investment income that exceeds 25% of gross income for the prior three consecutive years.

Tip: Violations of S corporation eligibility requirements are often found during audits of prior years’ tax returns. The IRS adopted a relief provision that can allow the S election to continue uninterrupted even if a violation is found.

Strengths

C Corporation Profits Are Taxed at Lower Corporate Rates: For shareholders in high tax brackets, converting to a C corporation allows corporate earnings to be taxed at a lower, flat corporate income tax rate of 21% on regular taxable income. Paying taxes at this lower rate allows the corporation to reduce cash outflow. Of course, if the earnings of the corporation are then distributed to the shareholders as dividends, then the dividends will be taxed at the shareholders’ tax rate, resulting in a “double tax.”

Note: Double taxation may be less of a drawback in 2018 and beyond, thanks to the Tax Cuts and Jobs Act of 2017, which reduced the business income tax rate that C corporations pay to a flat 21% (from a high of 35%). Moreover, individual owners of pass-through entities may be entitled to up to a 20% deduction on their share of qualified business income. Also, keep in mind that as a result of the Affordable Care Act of 2010, an additional 3.8% Medicare tax applies to some or all of the investment (e.g., dividend) income for married filers whose modified adjusted gross income exceeds $250,000 and single filers whose modified adjusted gross income is above $200,000.

C Corporations Offer Greater Potential for Raising Capital: Converting to a C corporation offers greater potential for raising capital than an S corporation, because the potential market for shares is larger. A C corporation has no restrictions on the number of shareholders it can have and the classes of stock it can offer. In contrast, an S corporation is limited to 100 shareholders and can offer only one class of stock. The ability to trade shares in a wider market, and to target different classes of stock to different investor groups, makes the shares of a C corporation more attractive to venture capitalists and investors.

C Corporations Can Offer a Broader Range of Tax-Deductible Fringe Benefits: Converting to a C corporation allows a company to offer a broader range of tax-advantaged fringe benefits compared to an S corporation. For example, accident and health insurance plans, group-term life insurance, and cafeteria plans are taxable as income for shareholders owning more than 2% of an S corporation. If the company converts to a C corporation, it can deduct the cost of these benefits from corporate revenue (as can the S corporation) but the employee-shareholders (owning more than 2%) can exclude them from taxable income.

Tradeoffs

Double Taxation of Profits: C corporation profits are taxed twice, first as corporate earnings and then when dividends are distributed to shareholders or when the company is liquidated.

Example: ABC, Inc., an S corporation, passes through earnings to its two shareholders, Ken and Bob, and these shareholders pay tax on the passed-through earnings based upon their marginal tax rates. Ken and Bob both pay tax at a marginal income tax rate of 35%. Assume each shareholder’s share of ABC’s income is qualified business income (QBI) and a 20% deduction is available. XYZ, Inc., a C corporation, pays corporate income tax at the rate of 21%. Frank and Jeff are the sole shareholders in XYZ, Inc. Dividends paid by XYZ, Inc. are taxed at the rates that apply to long-term capital gains. For Frank and Jeff, this means that the dividends they receive from XYZ, Inc. are subject to federal income tax at the rate of 15%. Both ABC, Inc. and XYZ, Inc. have net earnings of $100,000.

Caution: The examples do not take into account the marginal nature of income taxes. They are hypothetical and for illustrative purposes only. Due to the complex nature of business taxation, particularly in light of the Tax Cuts and Jobs Act and the complexity of the QBI deduction, it may be a good idea to seek the advice of an attorney or tax professional before making any decisions.

Shareholders Cannot Deduct Corporate Losses: C corporation losses remain in the corporation so shareholders cannot deduct them on their individual tax returns. In an S corporation, losses pass through to shareholders, who can deduct them against their personal income (subject to certain limitations).

Other Consequences May Result: A corporation that revokes its S election solely to reduce cash outflow may face other costs associated with becoming a C corporation. These may include the following:

• Increased state and local taxes may offset federal income tax savings
• The corporation may be prohibited from making another S election for five years, although the IRS can reduce this waiting period
• If the corporation were to sell most of its assets in the future, the sale would be subject to double taxation

How to Do It*

In General: A corporation can convert from an S corporation to a C corporation by revoking the S election voluntarily, or the IRS can terminate it. Consult a tax professional to ensure the conversion will not result in unforeseen and undesirable tax consequences.

Voluntary Revocation: A corporation can convert from an S corporation to a C corporation at any time. However, to be effective on the 1st day of the corporation’s taxable year, the corporation must revoke its S election by the 15th day of the 3rd month of that tax year. A revocation filed after the 15th day of the 3rd month of the tax year will take effect at the start of the corporation’s next taxable year.

Example: ABC Corporation’s tax year starts on March 1. If ABC Corp. wants to convert to a C corporation for the current year, it must notify the IRS by May 15 (the 15th day of the 3rd month of its tax year). Otherwise, C status won’t take effect until March 1 of the following year.

There is no specific form to revoke the S election. Simply take the following steps:

• File a statement titled “Revocation of S Corporation Status” with the IRS Service Center where the S election was filed. This letter should identify the name of the corporation, the tax identification number, and the number of outstanding shares.
• Have the statement completed and signed by the person authorized to sign the corporation’s tax returns–usually the president or a corporate officer.
• Attach a statement of consent signed by shareholders owning more than 50% of the stock, including the nonvoting shares.

Termination by Law: The IRS can terminate the S election for violating one or more of the eligibility requirements. Violations include having more than 100 shareholders; having 1 or more ineligible shareholders; or having more than one class of stock. A corporation can also become ineligible for S corporation status if it has accumulated earnings, profits, and passive investment income exceeding 25% of gross income for the prior three consecutive years. Terminations are generally effective on the date of the termination event.

*Checklist is not exhaustive

Tax Considerations

No Immediate Gain or Loss Realized upon Conversion: When an S Corporation converts to a C corporation, no immediate gain or loss is realized upon conversion.

Distributions Must Occur Within a Limited Time Period: If a corporation has not distributed all its earnings to shareholders when it terminates its S election, it has only a limited period in which to do so before the distribution of such earnings will be taxed as a dividend.

Midyear Terminations Require Two Tax Returns: A revocation or termination can occur at any time during a tax year. If it occurs midyear, the corporation must file two tax returns for that year.

Once Revoked, Waiting Period to Re-Elect S Status May Apply: Once the S election is revoked or terminated, the corporation cannot elect S status again for five years without IRS approval.

Since there is that aforementioned waiting period, make sure you understand all the consequences of changing your businesses entity type. If you have questions or need assistance, contact the Experts at Henssler Financial:

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