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C Corporation to S Corporation: Why the Hype?

March 2, 2017 | By | No Comments

Note: This article, originally posted March 2, 2017, has been updated as of November 27, 2018, by Benjamin Miller 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?

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 a 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[1] to sell such assets may allow shareholders to re-characterize the gain from ordinary to capital – a potential difference in tax rates of 20% (35% vs. 15%).

Double taxation of C corporation earnings

  • C corporation earnings are taxed at the entity level, up to 35%.
  • C corporation earnings distributed to shareholders as dividends are then taxed at the individual level, typically 15%.

– This is a 44.75% tax rate [2]

– Add in state corporate tax rates of 7.6% (in Oregon) and the total tax rate is 52.35%!

Favorable individual tax rates

  • An S corporation reports the results of its operations directly to shareholders on their individual tax returns. 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 due to lower tax brackets or the character of the income.

– For example: Federal rates may be as low as 15%, 25% or 28%. [3]

– Add in state tax rates of 9% and the total tax rate may be as low as 24%, 34% or 37% (compared to the 52.35% calculated above).

Savings on compensation

  • S corporations may not have to drive down earnings by increasing wages, which is a common C corporation strategy. [4]
  • What is the downside of increased wages? Increased payroll taxes.

– Wages are subject to payroll taxes of 7.65% on the first $118,500.

– Wages in excess of $118,500 are only subject to the Medicare tax of 1.45%. [3]

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

– Ineligible shareholders (e.g. foreign individuals, certain estates and trusts, etc.) [5]

– More than one class of stock (e.g. common and preferred) [5]

– More than 100 shareholders [5]

– Ineligible corporation (e.g. some financial institutions and insurance companies) [6]

– Or, you plan on selling the company within 5 years (i.e. the recognition period).

In other cases, you may just want to wait until a later year to pick up the additional income that might be caused by the conversion, such as:

– Recapture of LIFO in gross income last year of the C Corporation.

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 (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. [7] However, the most common method is to get an appraisal of all assets.

  • Determine Built-in Gains and Losses (IRC 1374)

– As mentioned above, the S corporation must determine the FMV of assets and compare to the adjusted tax basis. Any excess FMV is considered a “built-in” gain and will be subject to the highest corporate tax rate of 35% 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 be a very effective strategy to reduce taxes within the current rate structure. If you want more information about converting to an S corporation, reach out to Delap today to continue the conversation.

[1] IRC 1374(d)(7)

[2] [(1 x 0.35) + (.15 x (1 – 0.35)]

[3] Retrieved October 21, 2015 from: http://www.irs.gov/

[4] Now is the Time: Converting a C Corporation to an S Corporation or LLC, The Tax Advisor. Retrieved October 20, 2015, from: http://www.thetaxadviser.com/issues/2012/aug/lynch-august2012.html

[5] IRC 1361(b)(1)

[6] IRC 1361(b)(2)

[7] Rev. Ruling 59-60

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