C Corporation to S Corporation: Why the Hype?
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?
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.
Double taxation of C corporation earnings
- C corporation earnings are taxed at the entity level at a flat rate of 21%.
- C corporation earnings distributed to shareholders as dividends are then taxed at the individual level, up to 23.8% (20% LT capital gains tax + 3.8% net investment income tax).
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%!
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.
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.
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 $128,400 for 2018 ($132,900 for 2019).
Wages in excess of $128,400 are only subject to the Medicare tax of 1.45% per the Social Security Administration.
Reasons Not to Convert to an S Corporation
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.) (IRC § 1361(b)(1))
- More than one class of stock (e.g. common and preferred) (IRC § 1361(b)(1))
- More than 100 shareholders (IRC § 1361(b)(1))
- Ineligible corporation (e.g. some financial institutions and insurance companies) (IRC § 1361(b)(2))
- 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)
- 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)
- Recapture of LIFO in gross income last year of the C Corporation.
- There are net operating loss carryforwards (or other carryforwards) in the C Corporation that would be lost if converting to an S Corporation.
- Or, 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?
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. If you want more information about converting to an S corporation, reach out to Delap today to continue the conversation.