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Note: This article, originally posted March 2, 2017, has been updated as of January 18, 2022, by Brady Dixon, 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 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.
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%.
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.
For example, Federal rates range from 10% to 37% for the 2021 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 51.6% calculated above). For the 2022 tax year, the proposed tax rate change increases the highest bracket to 39.6%.
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)):
Wages are subject to payroll taxes of 7.65% on the first $142,800 for 2021 ($147,000 for 2022).
Wages in excess of $147,900 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.
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.
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: