Tax Implications When Converting Corporations



If you’re considering switching your C corporation into a S corporation, there are many things to think about. An S corporation could give you more tax advantages than a C corporation, but there are many tax implications that could negate the possible savings. Here are four of the most common issues business owners run into when converting their corporations.

LIFO: If your C corporation uses the last-in, first-out (LIFO) accounting method for inventory, you will be required to pay taxes on the benefits you got once you convert to a S corporation. You can spread the amount out over a maximum of four years.

Built-in gains: When your conversion to a S corporation becomes effective, you will be taxed on built-in gains that may be apart of the C corporation and realized within five years. This could be things like appreciated property. Usually, this doesn’t work in a new S corporation’s favor. However, there are circumstances where a conversion will still have a better tax result even with the built-in gains tax.

Passive income: Once your S corporation has a former history of being a C corporation, any of your passive investment income that’s over 25% of your gross receipts will be subject to a special tax. Passive investment income can be from dividends, stock sale gains, royalties, interest, and rents. This tax also come into play if the S corporation receives earning and profits from being a C corporation. You can avoid the tax by limiting the passive income amount or distributing the earnings and profits, making them taxable to shareholders. If you don’t pay the tax for three years in a row, your S corporation election terminates.

Unused losses: If your C corporation has unused net operating losses, you may have to consider whether or not the cost of forfeiting the losses is worth the tax savings you hope to gain by switching to a S corporation if the losses can’t be carried to a previous C corporation year. The losses can’t offset a C corporation’s income as a S corporation, and it can’t pass through to shareholders.

More to consider

There are many more aspects about converting to a S corporation that you need to know and be aware of before you make the election. There could be issues regarding shareholders who have outstanding loans from their qualified plans. Also, shareholder-employees won’t be able to get all the tax-free benefits they’d be able to have through a C corporation.
We can help you understand how certain factors will impact your situation and possible election. We’ll also help you come up with a plan and minimize taxes.

CAPATA is a full-service accounting firm located in Laguna Niguel in southern California.