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Note: This article, originally posted March 2, 2017, has been updated as of January 3, 2020, by Benjamin Miller, CPA, to reflect current rates and to consider the impact of 2018 tax reform.
If you are the owner of a closely held C corporation, chances are your accountant has mentioned something to you about converting to S corporation status. Maybe you listened; maybe you didn’t.
So, why does your accountant keep talking about S corporations anyway? We’ll cover the basics in this article.
Today, chances are slim that any real estate is still held in a C corporation. However, there may be some old C corporations out there that haven’t moved their real estate into an LLC. Or, there may be other business assets in the corporation that have appreciated significantly over time.
The catch: when you sell appreciated assets, all gains are taxed at ordinary rates in a C corporation.
Solution: converting to an S corporation and waiting for 5 years (IRC § 1374(d)(7)) to sell such assets may allow shareholders to re-characterize the gain from corporate rates facing double taxation to capital rates at the individual level.
This is a 39.8% tax rate. Then, when you add in state corporate tax rates of 7.6% (in Oregon) and the individual state income tax rate of 9.9% (in Oregon), the total tax rate is approximately 51.6%.
For example, Federal rates range from 10% to 37%. Add in state tax rates of 9.9% (Oregon) and the total tax rate may range from 19.9% to 46.9% (compared to the 51.6% calculated above).
Note: this does not account for the new Qualified Business Income Deduction available to many pass-through owners for tax years 2018 and forward. This deduction is not available for C Corporations, so the individual tax rate may be even lower when we factor in the deduction.
Wages are subject to payroll taxes of 7.65% on the first $132,900 for 2019 ($137,700 for 2020).
Wages in excess of $132,900 are only subject to the Medicare tax of 1.45% per the Social Security Administration.
In some cases, it may not be permissible or may not make sense to convert to an S corporation, such as:
Typically prepared by the tax preparer and must be signed by all shareholders.
Must file within two months and 15 days after the beginning of the tax year the election is to take place.
On the date of the S corporation conversion, the corporation must determine the Fair Market Value (FMV) of assets and compare to the adjusted tax basis of assets. The S corporation should be valued as if it remained a C corporation and had sold all its assets at fair market value to an unrelated party.
Determining FMV depends on the circumstances in each case. However, the most common method is to get an appraisal of all assets.
Any excess FMV is considered a “built-in” gain and will be subject to the corporate tax rate of 21% if the assets are sold within 5 years of the date of the S corporation conversion.
Note: post-election appreciation is not subject to the built-in gains tax.
As you can see, converting from a C corporation to an S corporation can still be a very effective strategy to reduce taxes in light of 2018 tax reform and the current rate structure.