Most business owners understand the importance of selecting the optimal corporate structure and tax status for their companies, but fewer know about the process, benefits and potential pitfalls of converting an existing business from a C-corporation to an S-corporation.
Smart Business spoke with Jay Lee, a tax specialist at Sensiba San Filippo LLP, to learn more about S-corp conversions and to get an analysis of the benefits of potential S-corp conversions — looking at both short and long-term costs, benefits and roadblocks.
What are the most important considerations for a company considering an S-corp conversion?
Business owners should take a comprehensive, long-term approach when considering an S-election. They must determine whether they qualify for S-corp filing status. S-corps can have no more than 100 shareholders, who must be U.S. citizens or resident aliens, and can only have one class of stock. C-corps with international owners or several classes of stock will not qualify to make an S-election. Companies should consider current funding and potential future methods of funding before electing to be taxed as an S-corp.
Tax ramifications may be the next decision point. At the federal level, income from a C-corp is taxed twice — once at the corporate level and second at the shareholder level when dividends are paid. In contrast, income from an S-corp is taxed only once at individual income rates, while distributions to shareholders can generally be made tax-free. Some states, however, impose a corporate-level tax for S-corps. For example, California imposes a lower 1.5 percent tax to S-corps compared to 8.84 percent to C-corps, providing additional incentive for conversion.
What critical issues could drive the decision to convert to an S-corp?
While the tax benefits of filing as an S-corp may seem straightforward, converting to an S-corp may have some lingering corporate level taxes from activity as a C-corp. For example, there is a net unrealized built-in gains (BIG) tax that imposes a corporate-level tax to an S-corp when disposing assets within the recognition period, which was five years in 2014 and currently 10 years for conversions occurring in 2015 and beyond. The tax is assessed on the amount that the fair market value exceeds the tax basis of an asset at the time of conversion. Proper planning should be considered when converting to an S-corp, as disposing of certain assets such as inventory may be inevitable in the normal course of business.
Special consideration should be made for cash basis corporate taxpayers. Assets such as accounts receivables may not appear on the face of the balance sheet and can be overlooked as an asset subject to BIG tax once the receivables are collected. An uninformed taxpayer may unexpectedly be hit with the BIG tax for sales or services performed as a C-corp and taxed at the highest corporate tax rate of 35 percent because of the conversion.
The BIG tax is subject to the highest corporate tax rate of 35 percent if assets are disposed of within the recognition period after conversion. Companies should be aware of corporate-level taxes as they are considering the conversion in order to manage cash flows and to allow for proper planning to minimize the tax effects.
How should business owners approach this important decision?
The decision to convert from a C-corp to an S-corp should be a well-planned, strategic decision that considers both short- and long-term plans for the business. While tax considerations are important, current and future ownership, funding considerations and the business owner’s exit strategies are also critical.
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