Converting an S Corporation to a C Corporation

This Week's Quote:

“You are never too old to set another goal or dream a new dream.”

                                  -Les Brown, Author

Entity choice is important for many reasons.  Asset protection and tax considerations are always near the top of the list.

As a business progresses through the five (5) phases of a life cycle: start-up, growth, maturity, renewal/rebirth/decline and succession– the factors that earlier prompted a particular choice of entity may change.  And, a new entity choice may become more appropriate. 

Here we will discuss one such change – that of an S corporation converting to a C corporation.  Each type of these two (2) entities are taxed very differently.  The S corporation is known as a pass-through entity.  That being said, it does not pay its own taxes but instead its shareholders pay the tax on its behalf.  The shareholder of the S corporation may be taxed as high as 37% (federal) or more, whereas a C corporation pays a flat 21% tax, a significant difference.  But some may argue that a C corporation may later be double-taxed which is true.  However, numerous ways are available to avoid that so-called double-tax scenario. C corporations also work well for family-owned companies that have or will have multi-generational shareholders.

Unlike going from a C corporation to an S corporation, a transition from an S to a C is much easier.

Let’s discuss some reasons that may prompt such a decision.

One of the more common ones is the failure of an S corporation to meet the IRS requirements.  More than 100 shareholders, a shareholder without a social security number, shareholders who are not U.S. citizens, and adding another class of stock are all reasons that may force a transition from S to C.  Another consideration is that C corporations tend to have less IRS audit risks than S corporations where self-employment taxes may be underpaid.

To accomplish this transition to a C corporation, a statement of revocation must be prepared and submitted to the appropriate IRS service center.  For the transition to be effective on January 1st, the revocation must be filed by March 15 of that same year.

-Mark Bradstreet
 

Many factors determine what kind of business structure your clients choose when starting their businesses. But whatever structure your clients launched with, at some point, for various reasons, changing structures may become a valid consideration. Although typically, clients choose to convert from a C Corp to an S Corp to avoid the C Corp’s double taxation, there are reasons to convert in the opposite direction. Here’s more to know about S Corp to C Corp entity conversions so you can help your clients make an informed decision.

Why a C Corp?

Your C Corp clients likely went in that direction for the liability protections and 21% flat tax rate inherent with the C Corp legal entity. Once a C Corp registers with the state, the company is considered a separate legal entity with its own independent financial and legal responsibilities. C Corp owners are employees/shareholders and receive salaries and dividends when (and if) dividend profits are distributed. Owners are not responsible for the corporation’s financial debts and legal liabilities as employees.

In addition, the Tax Cuts and Jobs Act of 2018 reduced the corporate tax rate to a flat 21%, which makes it attractive for some high-profit companies, although the organizational requirements may seem cumbersome. A C Corp must have an elected Board of Directors responsible for all critical business decisions. Also, a C Corp must create and file Articles of Incorporation and bylaws with the state, meet regularly, keep shareholder board minutes, and comply with the Secretary of State’s requirements for C Corps in each state where they conduct business.

Tax considerations also make C Corps stand apart from other legal structures. Because the corporation is a separate legal entity from the owners, the company is responsible for filing and paying its own taxes. Then the owners pay taxes on their salaries and dividends, causing “double taxation.” Some companies prefer to file taxes as an S Corp to avoid double taxation.

Why an S Corp?

The S Corp is an IRS election that changes the corporation’s tax status to a “pass-through entity” under Subchapter S of the Internal Revenue Code. S Corps, therefore, are not separate taxable entities—the profits and losses are “passed-through” and reported on the personal income tax returns of the shareholders.

Generally, an S Corp is exempt from paying federal income tax other than the taxes on some capital gains and passive income. S Corp shareholders can save on taxes by dividing the company income into wages and dividends. Also, as a business owner or an employee, your clients must pay Social Security and Medicare taxes. As an employee, your clients are only responsible for part of these taxes, and the company pays the balance. However, when your clients organize as an S Corp, they have the flexibility to classify some of the business’s income as salary and some as dividend distribution. That means your clients will still be subject to self-employment taxes on the wage portion of their income but pay only income tax on the dividend portion. Depending on how they divide their income, filing as an S Corp could save your clients a significant amount on self-employment taxes.

Why Convert to a C Corp?

Typically, S Corp business owners converting to a C Corp tax status do so because their companies no longer meet the IRS requirements for the S Corp election.

The qualifications for the S Corp election include:

• The company must file Form 2553 Election by a Small Business Corporation promptly—no more than two months and 15 days after the beginning of the tax year. S Corp status will begin the next calendar year if the business misses the deadline.

• Tax Form 2553 must be signed by all shareholders

• The company must be filed as a U.S. corporation

• Can maintain only one class of stock

• Limited to 100 shareholders or less

• Shareholders must be individuals, estates, or certain qualified trusts

• Requires each shareholder to have a U.S. Social Security Number

• All shareholders must be U.S. citizens or resident aliens

• The corporation must have a tax year ending on December 31

Consequently, if any of these requirements are not met, your clients must convert the company’s tax status. For example, your clients may want to bring on more than 100 shareholders, shareholders who are not U.S. citizens, or offer different kinds of stock. C Corps do not have limitations on the type of stock offered, the number of shareholders, or on the citizenship of shareholders.

Another reason for conversion is that the IRS tends to keep a close eye on S Corp returns, as the possibility for abuse is high. Business owners must be careful to portion themselves a “reasonable salary” consistent with position and responsibility—and not hide from payroll taxes by issuing excessive dividends.

Converting the S Corp to a C Corp

Fortunately, your clients can convert their S Corp to a C Corp at any time and with relative ease. The business must submit a “statement of revocation” to the state service center where their annual return is filed.

The revocation statement must state that the company wishes to revoke the election made under Section 1362(a). In addition, the statement should include:

• Name of the shareholder(s)

• Address of the shareholder(s)

• Federal Tax ID Number of the corporation

• Social security numbers of the shareholder(s)

• The number of shares of stock owned by the shareholder(s)

• The date (or dates) on which the stock was acquired

• The name of the S Corp

• The effective date of the revocation (or prospective date)

Finally, the statement must be signed by all shareholders who own more than 50% of the corporation’s issued and outstanding stock (whether the shares are voting or non-voting).

To have the conversion take effect on the first day of the company’s taxable year, your clients must submit the statement by the 16th day of the third month of the tax year, in other words, by March 15.

Entity conversions may seem like a complex decision for your clients; however, with your expertise and advice, the process can be accomplished seamlessly and win you a client for life.

Partial credit given to an article by Nellie Akalp in the October/November, 2022 edition of the CPA Practice Advisor.
 
Thank you for all of your questions, comments and suggestions for future topics. As always, they are much appreciated. We also welcome and appreciate anyone who wishes to write a Tax Tip of the Week for our consideration. We may be reached in our Dayton office at 937-436-3133 or in our Xenia office at 937-372-3504. Or, visit our website.
 
This Week’s Author, Mark Bradstreet