Does your business owe a tax bill? Choosing the right entity will make a significant difference. In certain circumstances, S corps can provide substantial tax advantages over C corps. However, there are many potentially costly tax issues you should evaluate before converting from a C corporation to an S corporation.
George Chan, CPA, a Senior Tax Associate with JLK Rosenberger says, “Making the right entity choice is the key to the success of your business.” Here is a quick breakdown of four issues to think about:
- LIFO inventories. If converted to S corporations, last-in, first-out (LIFO) inventories used by C corps have taxes to be paid on the benefits they derived through LIFO. Taxes owed could span over four years. This cost should be weighed against the potential tax gains from converting to S status.
- Built-in gains tax. S corporations are usually subject to tax, but S corporations that were formerly C corporations are taxed on built-in gains (example: appreciated property) that the C corporation has when the S election is effective, if the gains are still considered within five years following the conversion. While this is generally deemed unfavorable, there are situations where the S election can provide a better tax result despite the tax on built-in gains.
- Passive income. Former C corps are subject to a special tax. If their passive investment income (including interest, dividends, royalties, stock sale gains, and rents) exceeds 25% of gross receipt, and the S corp has accumulated earnings and profits carried over from the C corp, their tax will become effective. The corporation’s election to be an S corp will be terminated if the tax is owed for three consecutive years. This can be avoided by distributing accumulated earnings and profits, which is also taxable to shareholders. Alternatively, you could also limit the amount of passive income to avoid the tax.
- Unused losses. Unused net operating losses can’t be used to offset the income of a C corp as an S corp and can’t be transferred to shareholders. If the losses can’t be carried back to an earlier year for C corporation, it may be necessary to weigh the expected tax savings against the cost of giving up the losses when switching to an S corporation.
- Additional factors. There additional factors to think about when a business converts from C to S status. Another example would be when shareholder-employees of S corps can’t receive all the tax-free fringe benefits that are available with a C corp. Shareholders who have outstanding loans from qualified plans may face issues as well. These factors have to be considered in order to understand the implications of converting from C to S status.
We can explain how these factors will affect your company’s situation and come up with strategies to minimize taxes. For additional information, call us at 818-334-8636 or click here to contact us. We look forward to speaking with you soon.