Although
S corporations can provide significant tax advantages over C corporations in
the right circumstances, there are a number of potentially costly tax problems
that you should assess before making a decision to convert a C corporation to
an S corporation. Here's a quick rundown of the most important of these for you
to consider:
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
had when the S election becomes effective, if those gains are recognized within
10 years after the corporation becomes an S corporation. This generally is
unfavorable, although there are situations where the S election still can produce
a better tax result despite the built-in gains tax.
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.
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 earnings and profits,
which would be taxable to shareholders. Or you might want to avoid the tax by
avoiding recognition of passive income.
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. If you would like to discuss the effect of
these and other potential problems and possible strategies for dealing with
them, please call and schedule an appointment.