Insight

Tax issues to assess when converting from a C corporation to an S corporation

Tax issues to assess when converting from a C corporation to an S corporation | quickbooks consulting in washington dc | Weyrich, Cronin & Sorra

Operating as an S corporation may help reduce federal employment taxes for small businesses in the right circumstances. Although S corporations may provide tax advantages over C corporations, there are some potentially costly tax issues that you should assess before making a decision to switch.

Here’s a quick rundown of the most important issues to consider when converting from a C corporation to an S corporation:

Built-in gains tax

Although S corporations generally aren’t subject to tax, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) that the C corporation has when the S election becomes effective, if those gains are recognized within 5 years after the corporation becomes an S corporation. This is generally unfavorable, although there are situations where the S election still can produce a better tax result despite the built-in gains tax.

Passive income

S corporations that were formerly C corporations are subject to a special tax if their passive investment income (such as dividends, interest, rents, royalties and stock sale gains) exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If that tax is owed for three consecutive years, the corporation’s election to be an S corporation terminates. You can avoid the tax by distributing the accumulated earnings and profits, which would be taxable to shareholders. Or you might want to avoid the tax by limiting the amount of passive income.

LIFO inventories

C corporations that use LIFO inventories have to pay tax on the benefits they derived by using LIFO if they convert to S corporations. The tax can be spread over four years. This cost must be weighed against the potential tax gains from converting to S status.

Unused losses

If your C corporation has unused net operating losses, the losses can’t be used to offset its income as an S corporation and can’t be passed through to shareholders. If the losses can’t be carried back to an earlier C corporation year, it will be necessary to weigh the cost of giving up the losses against the tax savings expected to be generated by the switch to S status.

There are other factors to consider in switching from C to S status. Shareholder-employees of S corporations can’t get the full range of tax-free fringe benefits that are available with a C corporation. And there may be complications for shareholders who have outstanding loans from their qualified plans. All of these factors have to be considered to understand the full effect of converting from C to S status.

There are strategies for eliminating or minimizing some of these tax problems and for avoiding unnecessary pitfalls related to them. But a lot depends upon your company’s particular circumstances. Contact us to discuss the effect of these and other potential problems, along with possible strategies for dealing with them.

© 2022

 

Related Insights

Tax-favored Qualified Small Business Corporation status could help you thrive | accountant in elkton md | Weyrich, Cronin, and Sorra

Management Advisory Services & Business Consulting

Tax-favored Qualified Small Business Corporation status could help you thrive

Operating your small business as a Qualified Small Business Corporation (QSBC) could be a tax-wise idea. Tax-free treatment for eligible stock…
Should your business offer the new emergency savings accounts to employees? | tax accountant in washington dc | Weyrich, Cronin & Sorra

Management Advisory Services & Business Consulting

Should your business offer the new emergency savings accounts to employees?

As part of the SECURE 2.0 law, there’s a new benefit option for employees facing emergencies. It’s called a pension-linked emergency savings…
Update on IRS efforts to combat questionable Employee Retention Tax Credit claims | business consulting services in washington dc | Weyrich, Cronin & Sorra

Management Advisory Services & Business Consulting

Update on IRS efforts to combat questionable Employee Retention Tax Credit claims

The Employee Retention Tax Credit (ERTC) was introduced back when COVID-19 temporarily closed many businesses. The credit provided cash that…

Connect with us

Use the form below to send us an email. WCS responds directly to all inquiries and general questions within 24 hours of posting.

This contact form is deactivated because you refused to accept Google reCaptcha service which is necessary to validate any messages sent by the form.