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C Corporation to S Corporation: Why the Hype?

March 2, 2017 | By | No Comments

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