Converting from C corporation status to S corporation is a common change in business due the beneficial tax attributes afforded to shareholders. C corporations are “double taxed” in that they are subject to corporate-level income taxes at the entity level, and its shareholders are additionally subject to income taxes on both dividends and equity capital gains. S corporations, conversely, are not subject to income taxes at the corporate level. Instead, the S corporation’s income and deductions are “passed through” to the personal income tax returns of its shareholders based on their proportionate ownership interest. S corp shareholders to not pay taxes on distributions, and any retained income of an S corporation increases the tax basis of its shares, allowing the shareholders to avoid capital gains taxes on any stock appreciation upon a sale. It’s an attractive deal.
Before you consider converting your business, however, realize the decision to move into S corp status is not a slam dunk. There is a number of potentially expensive tax issues associated with the conversion. One of those implications is the Built-In-Gains (“BIG”) Tax, which applies if assets are sold or distributed within five years after the conversion. BIG Tax requires the corporation to measure the amount of unrecognized appreciation that existed at the time an S conversion was made. In order to do this, the fair market value of the corporation is measured at the effective date of the S election as compared to its tax basis. Any of this built-in gain remains subject to corporate level tax at the highest rate of tax applicable to corporations -- currently 35%.
But BIG Tax isn’t the most potentially costly issue. Gifting is. If business owners' succession planning involves the gift or bequest of all or part of their stock in the business entity, a change from a C corporation to an S corporation could increase the appraised fair market value of the entity by 50% or more. That’s an incredible jump, and it’s an issue business owners and their advisors need to tackle to before making the conversion.
If you’re considering converting your business from C corporation status to S corporation status, and gifting and/or sale of assets are in your future, here are a few items to consider with your advisor:
• Choose your valuation expert carefully. A good expert should be able to give a similar value for any business structure and be an expert witness if you’re questioned by a tax court.
• When possible, make gifts of stock prior to electing S corporation status.
• Get an appraisal to avoid understatement penalties.
• If the business entity is currently an S corporation, consider revoking the S election to get a lower appraised value for the stock.
The potential tax and legal consequences due to a conversion from a C corporation to an S corporation are great. It is extremely important that you consult your tax, business, and legal advisors before doing beginning the process. As always, we’re here to help.