Converting a C Corporation to an S Corporation – Is it the Right Time?

By Suzanne R. Lozano, CPA, CVA
Principal, Saginaw

On May 12, 2011, the Michigan Legislature passed two bills that repealed the Michigan Business Tax and created a 6% corporate income tax. Under these bills, S corporations will not be subject to the corporate income tax. Shareholders will pay only the individual income tax on business income. For corporations that have been contemplating electing S corporation status, this may be the time to assess the advantages and disadvantages.

Subchapter S of the Internal Revenue Code allows qualified corporations to be taxed as a flow-through so that income, gains, and losses pass through to the shareholder’s return without tax consequences to the corporation. S corporations can provide significant tax advantages over C corporations. However, a few significant tax consequences should be reviewed before deciding to convert from a C corporation to an S corporation.

Built-in gains tax

Normally, S corporations aren’t subject to tax. However, corporations that were previously C corporations are taxed on the net built-in gains that the C corporation had on the date the S election became effective if those gains are recognized. An example of this is appreciated property. A corporation holding assets worth $1,000,000 in market value with an adjusted basis of $400,000 has $600,000 of built-in gain on its balance sheet. If those assets are disposed of within 10 years (due to recent tax legislation, 5 or 7 years in certain instances), then those net built-in gains are subject to the maximum corporate tax rate, which is currently 35 percent.

In some instances, corporations may be subject to built-in gains tax even if they don’t dispose of any assets. If the corporation is a cash-basis taxpayer, then they may be subject to built-in gains tax when they collect an account receivable as an S corporation that accrued during the C corporation period.

It is very important to plan for built-in gains tax in order to minimize its impact. Valuing the corporation’s assets and liabilities through appraisals of the assets as of the date of the S corporation election is the crucial first step. This establishes the value as of the inception of the S corporation to ensure that appreciation that takes place after that date will not be subject to the built-in gains tax.

When a business valuation is done, one thing that should not be overlooked is the value of goodwill and other intangibles. These items may not have a value on the balance sheet, but often have a higher value than one would expect. It is important that an accurate appraisal is done as of the date of the S election in the event there is an IRS audit.

Unused losses

If you are a corporation and you have net operating losses that have not been used, and they are unable to be carried back to prior years, that must be taken into account when deciding whether to convert to an S Corporation. Those losses do not carry over to the S corporation and do not pass through to the shareholder -- they will be lost. The tax savings of switching to the S corporation will need to be weighed against abandoning the net operating losses.

LIFO inventories

C corporations that convert to S corporations and use LIFO inventories must pay tax on the benefits they derived by using LIFO. The tax may be spread over four years in equal installments. This is one consequence to consider when analyzing the conversion -- the cost of paying the tax verses the possible tax gains from converting to S status.

Passive income

S corporations that were formerly C corporations are subject to a special tax if their passive investment income (such as dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If this occurs for three consecutive years, the corporation’s election to be an S corporation terminates. One way this can be avoided is to distribute the earnings and profits, which would then be taxable to shareholders.

Weigh the factors

Before making a decision to switch from C to S status, it is important to weigh all factors from both the corporation’s viewpoint and the owners’ or shareholders’ viewpoint. A complete understanding of the tax effects is essential. A Certified Public Accountant, Certified Valuation Analyst or tax professional can help you make the right choice.