Is Switching Your Business from a C to an S Corporation a Good Idea?
Posted by Kerry Roets on May 27, 2024
Selecting the appropriate business entity is crucial due to its significant tax implications. The most prevalent business structures include sole proprietorships, partnerships, limited liability companies (LLCs), C corporations, and S corporations.
In some instances, a business may opt to transition from one entity type to another. While S corporations can offer considerable tax benefits compared to C corporations, there are several potentially costly tax issues that must be evaluated before deciding to convert from a C corporation to an S corporation.
Here are four critical considerations:
1. LIFO Inventories: C corporations utilizing the last-in, first-out (LIFO) inventory method must pay tax on the benefits derived from LIFO when converting to S corporations. This tax can be distributed over four years. It is essential to compare this cost with the potential tax savings from the S corporation status.
2. Built-in Gains Tax: Generally, S corporations are not subject to tax. However, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) present when the S election becomes effective, provided these gains are recognized within five years post-conversion. Despite being typically unfavorable, there are scenarios where electing S corporation status can still result in better overall tax outcomes.
3. Passive Income: S corporations that were previously C corporations face a special tax if their passive investment income (including dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts and they carry over accumulated earnings and profits from their C corporation years. If this tax is due for three consecutive years, the S corporation status will be terminated. This can be avoided by distributing the accumulated earnings and profits, taxable to shareholders, or by limiting passive income.
4. Unused Losses: Unused net operating losses from a C corporation cannot be utilized to offset income of an S corporation and cannot be passed through to shareholders. If these losses cannot be carried back to an earlier C corporation year, it is necessary to consider the cost of forfeiting these losses against the anticipated tax savings from switching to S corporation status.
Additional Considerations
These points are merely a few factors to consider when transitioning from a C corporation to an S corporation. For instance, shareholder-employees of S corporations do not qualify for all tax-free fringe benefits available to C corporations. Additionally, there may be implications for shareholders with outstanding loans from their qualified plans. It is vital to evaluate these aspects to fully understand the consequences of converting from C to S status.
If you are considering an entity conversion, contact us. We can clarify your options, outline their impact on your tax liability, and suggest strategies to minimize taxes.
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Kerry joined Lumsden McCormick with over 10 years of experience in areas of business tax and cost segregation along with tax compliance for individuals. Her experience includes real estate for hospitality, multifamily housing, and commercial properties; historic tax credits; partnerships; and private equity and family wealth.