Tax Challenges during C Corporation to S Corporation Conversion

Under the right circumstances, S corporations may provide significant tax advantages over C corporations, thus prompting many business owners to convert to the former. However, this conversion can foster a number of potentially costly tax challenges that should be assessed during the decision-making process. Four of the more significant challenges include:

1. Built-In Gains Tax: Though S corporations generally aren’t subject to tax, those that were previously C corporations are taxed on built-in gains—such as from the sale of appreciated property—that the C corporation had when the S election became effective. Built-In Gains Tax may apply for up to 10 years after the conversion depending on the year of the gain recognized.
2. LIFO Inventories: C corporations that use LIFO inventories as their accounting method pay tax on the benefits they received by using LIFO if they convert to S corporations, which can be spread over four years. This cost should be weighed against the potential tax gains from converting to an S corporation status.
3. Passive Income: S corporations that were previously C corporations are subject to a tax if their passive investment income—such as dividends, interest, rents, royalties and stock sale gains—exceeds 25 percent of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. Passive Income Tax over a three-year period can result in automatic termination of the S election.
4. Unused Losses: If a C corporation has unused net operating losses, the losses cannot be used to offset its income as an S corporation, and cannot be passed through to shareholders. So, if the losses cannot be carried back to an earlier C corporation year, it’s necessary to weigh the cost of giving up the losses against the tax savings expected by the conversion to an S corporation.

These tax challenges while converting from a C corporation to an S corporation are just a few of many factors to consider while making this important decision. There are strategies for eliminating or minimizing some of these challenges, but those strategies are highly dependent on a company’s unique situation. If your company is considering a C corporation to S corporation conversion, discuss it with your tax adviser.