The best choice of entity can affect your business in several ways, including the amount of tax you will pay. In some cases, businesses decide to switch from one entity type to another. S corporations can generally provide substantial tax benefits over C corporations (because of single level tax versus double tax); in some circumstances there are potentially costly tax issues that may be triggered before making the decision to convert from a C corporation to an S corporation. Full disclosure: there are some disadvantages to being an S Corporation, too.
4 Important Issues to Consider in Choosing a Business Entity
1. LIFO inventories
C corporations that use last-in, first-out (LIFO) inventories must pay tax on the benefits they derived by using LIFO if they convert to S corporations. The tax can be spread over four years. This additional tax cost must be weighed against the potential tax gains from converting to S status.
2. Built-in gains tax
Although S corporations generally do not pay tax, those that were formerly C corporations are taxed at the S Corporation level on built-in gains (such as appreciated property) that the C corporation had as of the date the S election became effective. These gains are recognized only for the first five years following the C-to-S conversion date. This is generally unfavorable, although there are situations where the S election still can produce a better tax result despite the built-in gains tax.
3. Passive income
S corporations that were formerly C corporations are subject to a special passive investment income tax. This tax kicks in if there is passive investment income (including dividends, interest, rents, royalties, and stock sale gains) that exceeds 25% of the company’s gross receipts AND the S corporation has accumulated earnings and profits carried over from its C corporation years. This passive investment income tax should be monitored closely as things can quickly go from bad to worst. If that tax is owed for three consecutive years, the corporation’s S election will be terminated. Ways to minimize this risk: 1. Distribute the accumulated C Corporation earnings and profits (this dividend would be taxable to S corporation shareholders) or 2. limit the amount of passive income.
4. Unused losses
If the C corporation has unused net operating losses, these “suspended” losses cannot be used to offset any corporation income and the losses cannot be passed through to shareholders. If the losses cannot be carried back to an earlier C corporation year, it will be necessary to weigh the cost of giving up these suspended losses against the tax savings expected to be generated by the switch to S status.
Other C to S Considerations
When a business switches from C to S status, these are only some of the factors to consider. For example, shareholder-employees of S corporations are not eligible to get all of the tax-free fringe benefits that are available to owner-employees of a C corporation. And there may be issues for shareholders who have outstanding loans from their qualified plans. Only certain individuals and trusts can own S Corporation stock. Finally, potential future increases to both C corporation and individual income tax rates need to be considered in the overall conversion analysis. These factors (and a few more) should be taken into account in order to understand the implications of converting from C to S status.
If you are interested in an entity conversion, please contact us so we can help explain your options, how they will affect your tax bill and some possible strategies you can use to minimize taxes.