Should You Convert a C Corporation to an S Corporation?

by ExpertEntrepreneur

Considering converting your C corporation to an S corporation? Here is what you need to know.

If you have a C corporation, you probably incorporated for legal protection of your personal assets. While incorporation does offer liability protection, it also allows you to issue stock to raise capital. At some point, you may wonder if it is a good idea to convert your C Corp to an S Corp for additional tax advantages.

There are some cases in which it makes sense to convert to an S Corporation. Here is what you should know about your options and the benefits.

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How to Covert Your C Corp

You have two main options: electing to be taxed as an S Corporation, or converting your C corp to a limited liability company. Both options eliminate double taxation, but converting to an LLC is much more expensive.

If you want to be taxed as an S Corporation, keep in mind not all corporations will qualify due to restrictive rules on stock classes, company structure, types of allowed shareholders and more. The easiest way to exit C status is converting to S Corp status by meeting these requirements:

  • Must be a domestic corporation
  • An S Corporation cannot have more than 100 shareholders, who must be U.S. citizens or residents, or certain estates, trusts and tax-exempt organizations.
  • The corporation may only have one class of stock outstanding.

Why Convert a C Corp to an S Corp?

S Corporations and limited liability companies (LLCs) have something in common: both are pass-through entities for tax purposes. With either entity, business earnings are not taxed at the corporate level but instead "passed through" to individual owners to avoid the double taxation that comes with a C corporation. This can be a huge advantage, especially as distributions paid to shareholders will not be taxable, unlike dividends with a C Corp.

An S corporation can also reduce payroll taxes. You will be allowed to pay yourself a reasonable salary and the rest of earnings may be taken as a distribution, which aren't subject to FICA/Medicare and payroll taxes.

When Converting is a Bad Idea

It is not always a good idea to convert to an S corporation. If you value inventory using the LIFO method, you will be subject to the LIFO recapture tax, and any difference between the LIFO value and FIFO value becomes taxable.

If your corporation has used tax incentives like Section 179 expense options, your assets will have a lower basis and the difference between this value and market value can be recalculated.

You will only be able to issue one type of stock and you will also be required to use a calendar year. If you use a fiscal year now and it is vital to operations, it is probably not worth it to convert your C Corp.

If you are considering converting your C corporation to an S corporation, discuss it with your attorney, accountant and a business service company like this before proceeding to decide if it will be a wise decision.

Updated: 05/09/2014, ExpertEntrepreneur
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