Converting a C Corporation to an S Corporation: Potential Tax Implications

Demystifying Valuation, Economic Damages + Forensic Accounting

In recent years, the number of companies converting from C corporation status to S corporation status has increased dramatically. One of the main reasons is to avoid double taxation. C corporations are taxed at the corporate level for federal income tax purposes. Additionally, the C corporation shareholders are also taxed on any capital gains realized by the shareholder and on any dividend income distributed from the C corporation. However, the shareholders of an S corporation pay only one level of federal income tax. This is because the S corporation does not pay any federal income tax but rather passes it through to the S corporation shareholders.

If a company meets the eligibility requirements for conversion from a C corporation to S corporation (*) , the next step is to recognize that there is a number of potentially costly tax issues associated with the conversion. One of the primary tax implications is the Built-In-Gains (“BIG”) Tax, which applies if assets are sold or distributed within five years after the conversion (**). BIG Tax requires the corporation to measure the amount of unrecognized appreciation that existed at the time an S conversion was made. In order to do this, the fair market value of the corporation is measured at the effective date of the S election as compared to its tax basis. Fair market value is defined in Revenue Ruling 59-60 as follows (***):

The price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.

The amount of unrecognized gain is determined for each separate asset. This includes assets that are not reflected on the corporation’s balance sheet such as goodwill, patents and trademarks. The net of unrecognized built-in gains and built-in losses is the company’s unrecognized built-in-gain. Any of this built-in gain recognized during the five-year period beginning with the first day of the first tax year for which the corporation was an S corporation remains subject to corporate level tax at the highest rate of tax applicable to corporations (currently 35%).

In order to document the assets on hand and keep track of their future sale, a qualified appraisal to determine fair market value is essential. Statutory presumptions applicable to the built-in gains tax effectively require taxpayers to prove their case to the IRS’s satisfaction. All gains recognized by an S corporation during this recognition period are presumed to be recognized built-in gains, except to the extent the taxpayer establishes that a portion of the gain constitutes post-conversion appreciation or that the asset was not held at the beginning of the recognition period. Without a qualified appraisal, the corporation runs the risk of subjecting the entire gain from a sale to corporate level tax during the entire recognition period.

Understanding the potential tax consequences due to a conversion from a C corporation to an S corporation is extremely important and typically requires the involvement of a tax adviser, legal counsel and a business valuation professional.

More on S Corporations: Can they lose their status?

If you have any questions on the above, feel free to contact a Henry+Horne professional, who is eager to help you.

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(*) Eligibility requirements can be found in IRC Section 1361 and the corresponding Regulations.

(**) Before 2009, the BIG tax applied to gains recognized during the first 10 years after the S election was effective. In 2009 and 2010 this was shortened to 7 years and temporarily shortened to 5 years in 2011. The American Taxpayer Relief Act of 2012 extended the 5 year recognition period to 2012 and 2013. H.R. 4453 would amend the Internal Revenue Code to make permanent a 5 year recognition period, retroactive to January 1, 2014.

(***) Source: Sec. 2.02, Revenue Ruling 59-60, 1959-1 C.B. 237, Internal Revenue Service.

Sources: Tax Implications of Converting from a C-Corporation to a S-Corporation, by Nicholas P. Hoeft, November 2011

The Tax Adviser, Now is the Time: Converting a C Corporation to an S Corporation or LLC, by Michael F. Lynch, J.D., CPA, David B. Casten, J.D., LL.M., CPA, and David Beausejour, J.D., CPA, August 1, 2012

The Tax Adviser, The S Corporation Built-In Gains Tax: Commonly Encountered Issues, by Kevin D. Anderson, CPA, J.D., March 1, 2012

Comments

  1. Madeline says:

    I just formed a new business in August 2015. I’d like to change that to s corp from c corp. Can I still do that? If so, is that a potential problem for me? Please advise, what do I need to know and do? Please help. Thank you in advance!

    • admin says:

      Madeline –

      Thank you for your question and interest in our blog. You should consult with your CPA; however, since no tax return has likely been filed yet, you can probably get late election relief and still do the S Corp for 2015. The year-end would have to be December 31 as an S Corp.

      Cindy Andresen, ASA

  2. If we convert from a C to an S how is inventory considered? Does sale of product inventory incur a BIG Tax when it is sold as part of the normal ongoing business?

    Nathan Nelson