Convert C to S Corp: Save Thousands and Avoid BIG Tax Problem

When considering how to convert your C corporation into an S corporation, it is crucial to understand and prepare for the built-in gains (BIG) tax.

The BIG tax is applied when an S corporation recognizes gains on assets held by the C corporation at the time of conversion. This tax can catch many business owners off guard, especially because the conversion often requires switching from cash to accrual accounting.

For instance, if your C corporation operates on a cash basis and has outstanding receivables at the time of conversion, your new S corporation might continue using the cash basis. However, as it collects these receivables, it will still face the BIG tax.

The BIG tax is calculated in two parts: First, a 21% tax rate is applied, equivalent to the C corporation rate. The remaining 71% of profits are then passed through to the shareholders of the S corporation, where they are taxed at individual income tax rates, which can go as high as 40.8%.

We’re here to show you exactly how to convert your C corporation to an S corporation!

What is a C Corporation?

A C Corporation (C Corp) is a business entity legally separate from its owners, known as shareholders. It is one of the most common and traditional forms of corporation in the United States, offering a robust structure for businesses of all sizes.

Structure of a C Corporation

• Legal Entity: A C Corp is an independent legal entity, meaning it can enter into contracts, sue or be sued own assets, and is responsible for its debts and liabilities. This structure provides limited liability protection to its shareholders, who are not personally responsible for the company’s debts or legal obligations.
• Shareholders: A C corporation’s ownership is divided into shares, which can be bought and sold. Shareholders are the corporation’s owners, and they elect a board of directors to oversee the company’s management.
• Board of Directors: The board of directors is responsible for making major decisions and overseeing the company’s management. They appoint officers (such as the CEO, CFO, etc.) to handle day-to-day operations.
• Perpetual Existence: A C Corp continues to exist even if the original owners or shareholders leave or pass away. This feature allows for continuity and long-term planning.

How C Corporations are Taxed

• Double Taxation: One of the defining characteristics of a C Corp is its taxation structure. A C Corp is taxed as a separate entity from its owners, which leads to what is commonly known as “double taxation.”
  • Corporate Tax: The corporation pays taxes on its profits at the corporate income tax rate.
  • Shareholder Tax: When the corporation distributes profits to shareholders as dividends, those dividends are taxed again at the individual shareholder’s income tax rate.
• Tax Deductions: C Corps can deduct certain business expenses, including employee salaries, health benefits, operating expenses, and advertising costs, which can reduce their taxable income.

What is an S Corporation?

An S Corporation (S Corp) meets specific Internal Revenue Code requirements and has elected to be taxed under Subchapter S of the Code. This election allows the corporation to pass income directly to shareholders and avoid the double taxation that typically applies to C Corporations.

Key Features of an S Corporation

• Legal Entity: Like a C corporation, an S corporation is a separate legal entity from its owners, offering the same limited liability protection. Shareholders are not personally liable for the business’s debts and liabilities.
• Pass-Through Taxation: The most significant feature of an S Corp is its tax treatment. Instead of the corporation paying income taxes, profits and losses are “passed through” to shareholders, who report them on their tax returns. This avoids the double taxation faced by the C Corps.
• Shareholder Restrictions: S Corps are limited to 100 shareholders, all of whom must be U.S. citizens or residents. Additionally, S Corps cannot have corporations, partnerships, or non-resident aliens as shareholders. Only individuals, certain trusts, and estates are eligible.
• Single Class of Stock: S Corps can issue only one class of stock, meaning all shareholders must have equal rights to distributions and liquidation proceeds. However, differences in voting rights are allowed.
• Corporate Formalities: Like C Corps, S Corps must follow corporate formalities such as holding regular meetings, maintaining records, and filing annual reports.

Tax Treatment of an S Corporation

• Pass-Through Taxation: As an S corporation, the business does not pay federal income taxes. Instead, profits and losses are passed through to shareholders, who report them on their individual tax returns. This avoids the double taxation that applies to C Corporations.
• Self-Employment Taxes: Shareholders who work for the S Corp must be paid a reasonable salary subject to payroll taxes. However, any remaining profits distributed as dividends are not subject to self-employment taxes, potentially reducing the overall tax burden.
• Tax Deductions: S Corps can deduct business expenses like salaries, benefits, and other operating costs. Shareholders may also deduct business losses on their tax returns, subject to certain limitations.

Why Consider Converting from C Corp to S Corp?

• Reduce Double Taxation: Avoid paying taxes at both the corporate and individual levels.
• Lower Overall Tax Burden: Pass-through taxation can result in significant tax savings.
• Avoid Accumulated Earnings Tax: Eliminate tax on retained earnings not distributed to shareholders.
• Minimize Personal Liability: Benefit from limited liability while enjoying tax advantages.
• Flexible Profit Distribution: Distribute profits as dividends, potentially reducing self-employment tax.
• Simplify Tax Reporting: Pass-through taxation simplifies tax reporting compared to C Corp requirements.
• Attract Tax-Efficient Investment: Appeal to investors seeking favorable tax treatment.
• Tax Benefits for Shareholders: Shareholders may deduct business losses on their personal tax returns.

Tax Savings: How Much Can You Save?

• Example 1: A C corporation with a $200,000 profit pays $42,000 in corporate taxes, while an S corporation avoids this.
• Example 2: An S Corp shareholder saves on self-employment taxes by receiving dividends instead of all salary.
• Case Study 1: Business X converted to S Corp, saving $20,000 annually by avoiding double taxation.
• Case Study 2: Company Y saved $15,000 in self-employment taxes by distributing profits as dividends.
• Pass-Through Taxation: Only individual tax rates apply, avoiding the additional corporate tax rate.
• Tax Savings Strategy: Shareholders report income on personal returns, possibly benefiting from lower tax brackets.
• Reduced Tax Burden: Eliminates corporate tax, reducing overall tax liability for the business.

Five Strategies to Avoid Big Tax

To help you navigate and potentially avoid the BIG tax, here are five strategic approaches to consider:

1. Avoid Selling the S Corporation During the Five-Year BIG Tax Penalty Period

The BIG tax applies if the S corporation sells or disposes of assets held when it was a C corporation within five years after the conversion. To avoid triggering the BIG tax, holding onto these assets for at least five years is essential. This approach requires careful planning to align your business strategy with this holding period. By doing so, you can potentially sidestep a significant tax liability. Think ahead and structure your sales and transactions around this critical timeframe to minimize your exposure to the BIG tax.

2. Identify Personal Goodwill and Get a Proper Appraisal

Personal goodwill is the value of the business that can be directly attributed to the owner’s individual skills, relationships, and reputation rather than to the corporate entity. Unlike corporate assets, personal goodwill is not subject to the BIG tax. You must distinguish between corporate and personal goodwill through a proper appraisal to take advantage of this. Engage a qualified valuation expert to conduct a thorough assessment and document the non-corporate nature of this goodwill. This documentation can be crucial in proving to the IRS that certain assets should not be taxed as part of the corporation’s built-in gains.

3. Reduce Building Appreciation with an Accurate Appraisal

If your corporation owns real estate or other appreciating assets, an accurate appraisal can help mitigate the impact of the BIG tax. At the time of conversion, ensure that the property’s value is appraised fairly and reflects the current market conditions. This strategy helps set a higher base value for the assets, reducing the taxable built-in gain when the asset is sold. Proper appraisals can minimize the difference between the asset’s current market value and its original cost basis, ultimately reducing the amount subject to the BIG tax.

4. Give Yourself a Bonus

Issuing bonuses to yourself or key employees before the conversion can help reduce the corporation’s accumulated earnings and profits. Paying out bonuses reduces the corporation’s cash reserves or receivables, which could otherwise be considered built-in gains. This strategy must be executed correctly to align with corporate objectives and tax regulations. Bonuses should be reasonable and justifiable to withstand scrutiny by the IRS, and they must be paid before the conversion takes place to have the desired tax effect.

5. Establish Unpaid Compensation as a Liability and Pay It Promptly

If your C corporation has unpaid compensation from previous years, you can establish this amount as a liability on the books. The S corporation should pay this compensation within two and a half months after the conversion. By doing so, you create a built-in loss that offsets other built-in gains, thereby reducing your overall tax liability. This strategy requires meticulous record-keeping and demonstrating that the compensation was legitimately earned in prior years and deferred. Ensure that you meet all timing requirements to create this built-in loss successfully.

Considerations Before Converting from C Corp to S Corp

• Ownership Structure Changes: Verify eligibility, as S Corps have limits on the number and type of shareholders.
• Impact on Shareholders: Evaluate how the conversion affects shareholder dividends, distributions, and overall tax liabilities.
• State-Specific Regulations: Check state laws for S Corp recognition and any additional state-level taxes or compliance requirements.
• Timing of Conversion: Plan the conversion timing to align with fiscal year-end and avoid mid-year complications.
• Short-Term Tax Implications: Assess potential short-term tax consequences, such as built-in gains tax or adjustments in asset valuations.
• Profit Distribution: Consider how profit distribution changes under S Corp rules and its effect on shareholders’ income.
• Corporate Formalities: Prepare for ongoing compliance with S Corp requirements, including maintaining proper records and shareholder meetings.
• Consult a Tax Professional: Seek expert advice to navigate complex tax implications and ensure a smooth transition.

By implementing these strategies, you can minimize the potential impact of the BIG tax when wanting to convert your C corporation to an S corporation, preserving more of your hard-earned assets and reducing your overall tax burden.