Although S corporations can provide significant tax advantages over C corporations in the right circumstances, there are a number of potentially costly tax problems that you should assess before making a decision to convert your C corporation to an S corporation.
Built-in Gains Tax
Although S corporations generally aren't subject to tax, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) that the C corporation had when the S election becomes effective, if those gains are recognized within 10 years after the corporation becomes an S corporation. This generally is unfavorable, although there are situations where the S election still can produce a better tax result despite the built-in gains tax.
C corporations that use LIFO inventories have to 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 cost must be weighed against the potential tax gains from converting to S status.
S corporations that were formerly C corporations are subject to a special tax if their passive investment income (such as dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If that tax is owed for three consecutive years, the corporation's election to be an S corporation terminates. You can avoid the tax by distributing the earnings and profits, which would be taxable to shareholders. Or you might want to avoid the tax by avoiding recognition of passive income.
If your C corporation has unused net operating losses, the losses can't be used to offset its income as an S corporation, and can't be passed through to shareholders. If the losses can't be carried back to an earlier C corporation year, it will be necessary to weigh the cost of giving up the losses against the tax savings expected to be generated by the switch to S status.
There are other factors to consider in switching from C to S status. Shareholder/employees of S corporations can't get the full range of tax-free fringe benefits that are available with a C corporation. And there may be complications for shareholders who have outstanding loans from their qualified plans. All of these factors have to be considered to understand the full effect of converting from C to S status.
There are several different strategies for eliminating or minimizing some of these tax problems and for avoiding unnecessary pitfalls related to them. But a lot depends upon your company's particular circumstances. Consult an attorney to discuss the effect of these and other potential problems and possible strategies for dealing with them. You can also learn more about the advantages of the different types of corporate tax structures by visiting our Coporate Counsel section which has useful articles on a variety of topics designed to help you succeed in the corporate world and beyond.