Many small companies are set up as Type “C” Corporations (“C Corp”), particularly those which have been in existence for many years. However, C Corps are subject to double taxation, and as a result, businesses may want to consider converting to an S Corporation (“S Corp”) to reap the tax benefits.
Tax treatment of C Corps vs S Corps
C corporations must pay taxes on earnings at the corporate level. In addition, their shareholders are also separately taxed on amounts distributed to them as dividends. Therefore, each dollar earned by a C Corp is taxed twice before it reaches the hands of the corporation’s shareholders.
On the other hand, in an S Corp, income is taxed only once, with the tax being paid by the corporation’s shareholders. As a “pass through” entity, the S Corp’s income is included by its shareholders on their personal tax returns. With few exceptions, there is no second layer of tax when funds are later distributed by the S Corp to its Shareholders. In addition, corporate operating losses are passed through to its shareholders and can be used to offset “passive” income on the shareholder’s personal tax returns.
S Corp Shareholders can use corporate losses immediately after an S Corp election with no waiting period. In contrast, losses of a C Corp can only be utilized by the corporation to offset corporate income, and if a C Corp has no income, losses are built up by the C Corp for future use.
It should be noted that trusts can also take advantage of the tax benefits of S Corps, which is beneficial for estate planning and asset protection purposes.
Converting to an S Corp
A business set up as a C Corp, can elect to be converted to an S Corp simply by filing an election with taxing authorities (provided that its shareholders are eligible S Corp shareholders). However, taxing authorities would lose considerable tax revenue if all C Corps could avoid paying corporate level tax on all capital gains or accumulated earnings merely by electing S Corp treatment. As a result, the Internal Revenue Code imposes the following limitations or conditions on such a change:
- Sale of appreciated property. If an S Corp that was formerly a C Corp sells appreciated property within 5 years of converting to an S Corp, it must pay additional tax on any appreciation in the property value which took place prior to the S Corp election. This is known as a “built in gain” tax and is paid in addition to the tax paid by the S Corp shareholders on the total gain for the sale. However, if the corporation waits 5 years after converting to an S Corp to sell the property, no separate “built in gain” tax applies. Instead, the gains on the sale of property are taxed only once to the shareholder, and can then be distributed by the S Corp tax free to the shareholders.
- Retained C Corp earnings. Where a C Corp has built up profits which have not been distributed, the C Corp cannot avoid double taxation by converting to an S Corp. Instead, as of the date the entity becomes an S Corp, the company must separately track the C Corp and S Corp income.
Pre-conversion undistributed C Corp income is tracked separately in an “Earnings & Profits” account. This E&P account balance will never go up, but eventually will go down as E&P is distributed. If distributions are made from the E&P account, they will still retain C Corp treatment and be subject to double taxation.
On the other hand, the S Corp income is tracked in what is known as an Accumulated Adjustments Account. These distributions receive S Corp treatment and are subject only to single taxation.
It should be noted there is no requirement that distributions be made from the E&P first. A company has the authority to designate whether distributions are made from the E&P or AAA account. This allows the business to defer double taxation on E&P indefinitely. However, there are risks. Accumulated but undistributed E&P may be subjected to a punitive “accumulated earnings tax” assessed by the IRS.
If you are considering converting your C Corp to an S Corp, speak to a qualified attorney about whether it is the right choice for your corporation.
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This post does not constitute legal advice or establish an attorney-client relationship.