Note: This article, originally posted March 2, 2017, has been updated as of February 13, 2023, by Brady Dixon, CPA, to reflect current rates and to consider 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.

Appreciated Assets

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 5 years (IRC § 1374(d)(7)) to sell appreciated assets may allow shareholders to re-characterize the gain from corporate rates facing double taxation to capital rates at the individual level. The 5 years is known as the recognition period for tax imposed on appreciated assets, also known as built-in gains.

Double Taxation of C Corporation Earnings

• C corporation earnings are taxed at the entity level at a flat rate of 21% for the 2022 tax year.
• C corporation earnings distributed to shareholders as dividends are then taxed at the individual level, up to 23.8% (20% long-term capital gains tax + 3.8% net investment income tax).

This is a 44.8% tax rate from the federal tax rates only. 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 62.3%. The assumption is that the corporate and individual taxpayers are at the highest marginal tax rates.

Note: Prior earnings & profits from a C corporation continue to be a factor on S corporations. S corporation shareholders should be mindful of the distributions they receive. The portion of distributions in excess of S corporation earnings, also known as accumulated adjustments account (AAA), will be treated as a taxable dividend (IRC 1368(c)(2)), subject to the 23.8% tax rate mentioned above.

Favorable Individual Tax Rates

• An S corporation reports the results of its operations directly to shareholders on their individual tax returns, summarized on a Schedule K-1 for each shareholder. Therefore, S corporations are considered pass-through entities and generally do not pay tax at the entity level.
• Since pass-through income is separately stated and taxed at the individual shareholder’s tax rates, the shareholder may be in a position to take advantage of lower rates.

For example, Federal rates range from 10% to 37% for the 2022 tax year. 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 62.3% calculated above). 

Note: this does not account for the new Qualified Business Income Deduction (IRC 199A) available to many pass-through owners for tax years 2018 and forward. This deduction is not available for C Corporations, so the individual effective tax rate may be even lower when we factor in the deduction. The deduction is the lesser of (IRC 199A(b)(2)):

• 20% of the taxpayer's qualified business income with respect to any qualified trade or business.
• The greater of:
  • 50% of the Wu-2 wages with respect to the qualified trade or business
  • The sum of 25% of the W-2 wages with respect to the qualified trade or business, plus 2.5% of the unadjusted basis immediately after acquisition of all qualified property (for example, fixed assets)

Savings on Compensation

• S corporations may not have to drive down earnings by increasing wages, which is a common C corporation strategy.
• What is the downside of increased wages? Increased payroll taxes.

Wages are subject to payroll taxes of 7.65% on the first $147,000 for 2022 ($160,200 for 2023).

Wages in excess of $147,000 are only subject to the Medicare tax of 1.45% per the Social Security Administration. Wages paid to an employee in excess of $200,000 are subject to an additional 0.9% Medicare tax.

Reasons Not to Convert to an S Corporation

In some cases, it may not be permissible or may not make sense to convert to an S corporation, such as:

1. Ineligible shareholders (e.g. foreign individuals, certain estates and trusts, etc.) (IRC § 1361(b)(1))
2. More than one class of stock (e.g. common and preferred) (IRC § 1361(b)(1))
3. More than 100 shareholders (IRC § 1361(b)(1))
4. Ineligible corporation (e.g. some financial institutions and insurance companies) (IRC § 1361(b)(2))
5. The desire to maintain a fiscal year-end (S corporations are generally limited in the ability to choose a fiscal year-end other than the last three months of the year)
6. Certain situations when a corporate structure results in a greater tax benefit than a pass-through entity structure (especially given the changes with 2018 tax reform).
7. Recapture of LIFO in gross income last year of the C Corporation.
8. There are net operating loss (NOL) carryforwards (or other carryforwards) in the C Corporation that would be lost if converting to an S Corporation or not utilized within the 5-year recognition period.
9. You plan on selling the company within 5 years (built-in-gain recognition period – see below).

How Much Work is it to Convert to an S Corporation?

• File Form 2553: Election by a Small Business Corporation (IRC § 1362(a))

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.

• Valuation to determine built-in-gains and losses (IRC § 1374)

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.

Exit Planning Strategies

Whether you're looking to sell your company in the short- or long-term, understanding different sale structures is extremely important to maximize financial and tax planning strategies for yourself and investors. Selling a company structured as a C corporation or S corporation and whether converting to a S corporation is worth a discussion. Some of the factors to consider when structuring a sale, whether as a C corporation or S corporation, are:

• Asset vs. stock sale.
• IRC 338(h)(10) – Deemed asset sale and liquidation.
• IRC 1202 – Partial exclusion for gain from certain qualified small business stock (QSBS)
• IRC 1244 – Losses on small business stock.
• Sales price consideration – whether the sale can be structured as only cash deal, rollover equity, or a mix of both.

Do You Have Questions?

If you are considering converting from a C corporation to an S corporation or if you have other entity selection questions, our tax and business advisory teams would love to help.

Contact a Delap Advisor