Steve A Porter, CPA

Life used to be simple. You only had two or three channels on your television, your AM radio DJ selected your music for you, and there was no such thing as texting.

And if you started a business, you either incorporated, or you did not.

Most people who did go into business decided it best to form a corporation, however; The main reason being the legal protection granted with a separate entity which protects business owner’s personal assets.

The following assumes you already are set up as a C-Corp and you are thinking about converting. If you are not sure what type entity you have, take a look at your last tax return. If you filed a federal form 1120 (not a 1120-S), you are a C-Corp, and converting to an S-Corp might be a benefit to you, so please keep reading!

What are my options?

These days, instead of the traditional C-Corporation, a business has can choose, among other things, to be an S-Corporation or a Limited Liability Company (LLC). The advantage of these style entities is that they are pass through entities. This means that, like a sole proprietorship, the earnings of the company become part of the owner’s income, and all taxes are paid by the shareholder thus avoiding entirely corporate level taxation. Also, distributions, as opposed to dividends, are paid to the shareholder and unlike dividends, distributions are not taxable.

S-Corps (aka Subchapter S corporations) have been around for quite some time, but they became very popular in the 1980’s when personal tax rates dropped below corporate rates. The US economy also began to change, and we saw a surge in new small business startups which is the type business most suited for Subchapter S status. Note too, it was in that time that the other popular entity for small businesses became available: LLCs.

There are still a number of C-corps around, however. Many of them would benefit from filing as an S-Corp. Given the popularity and advantages of this type entity, a C-Corp owner might be wondering if it would pay to convert to an S-Corp. The good news is that it is not too hard to do, but the bad news is that it might not be feasible from a cost/benefit perspective.

Generally speaking, it is not a good idea to convert a C-Corp to an LLC since this involves recognizing a gain on the assets of the company and creating taxes on both the gain and the cash generated when distributed to the owner(s). But changing to an S-Corp is doable, and may offer several advantages.

Why change my C-Corp to an S Corp?

Probably the main reason people like S-Corporations is the pass through method of taxation. In a traditional corporation, the profits are taxed at the corporate level, and distributions from earnings are made via dividend. This means both the corporation and the shareholder must pay taxes. And in the case of dividends, there is actually double taxation

Also most people pay a lower amount of payroll taxes in an S-Corporation. As long as your compensation is reasonable, you can pay yourself a modest salary and take the remaining earnings out as a distribution. Since distributions are not subject to FICA/Medicare and other payroll taxes, you will benefit from less taxes.

Note that changing from “C” to “S” does change your corporate legal entity. You are still a corporation, and you not have to re-incorporate, and your original articles of incorporation apply. It is a good idea to amend them, however. Also, documenting the change in the minutes of your corporation’s board meeting is highly recommended. You’ll need to file the appropriate forms with the IRS. Your CPA should be able to handle that for you.

What is the downside?

Do you value your inventory using the LIFO method? Is so, you will be subject to LIFO recapture tax, and in my experience this can be a deal breaker. Essentially, the difference in your LIFO and FIFO value (this amount is called the LIFO Reserve) become a taxable income.

Fortunately, the income is taxed over four years, so if your LIFO reserve is $600,000.00, your corporation will pay taxes on $150,000.00 for four years. At 34% this is $51,000.00 per year. Is it worth it? For many, the answer is no.

If you do not use LIFO, the other item that might cause problems are built-in gains. Thanks to recent tax incentives, many businesses have assets that have a very low basis. This comes about by using section 179 expense options, and more recently, bonus depreciation. This causes the tax basis to be well below the fair market value in most cases, and this difference must be calculated and presented on the tax return of the new S-Corp.

The good news here is that you do not pay taxes on this gain until it is sold. If it is sold during the holding period (currently 10 years), the gain is taxed at the corporate rate of 35%, and is taxed separate from other gains and losses generated by the new S-Corp. The thrust of the built in gains regulations is to keep a C-Corp from converting to a S-Corp, and then immediately selling off assets to take advantage of lower tax rates in the new S-Corp.

Other Issues

Other problems relate to business structure. For example, you can only have one class of stock. Also, you can only have 100 shareholders. For most small businesses however, these are not problems.

Another problem might arise if your current corporation uses a fiscal year, ie; a year that does not end December 31. S-Corps are generally required to use a calendar year unless it can be shown that the majority of the owners use a fiscal year. When converting to an S-Corp, most people simply convert to a calendar year. If a fiscal year is crucial to your business operations, this might preclude you from converting to an S-Corp

So, should you change your C-Corp to an S-Corp? The short answer: it depends. For many small businesses, this is an ideal move, but every business and every situation is different. Your CPA is a good place to start if you are considering this change.

Questions? Please use the CONTACT FORM to get further information, and thanks for reading!

Republished by Blog Post Promoter