By Peter Watts
With the passage of Measure 67, some commentators have encouraged business owners to convert their C corporations into S corporations to avoid the C corporation's gross receipt tax. While there are many benefits to operating as a corporation under Subchapter S of the tax code, the conversion is not a step that should be taken without a full analysis of the actual and potential tax ramifications. S corporations have limitations on the type and number of shareholders. In addition, there are limitations on the number of classes of stock and key limitations on the differences between the two classes of stock.
Beyond the initial obstacles to a conversion, there are negative tax attributes that can be triggered.
Built-in Gains Tax. Although one of the primary reasons to incorporate as an S corporation is the pass-through tax treatment, 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 ten years after the corporation becomes an S corporation. The American Recovery and Reinvestment Act of 2009 reduces that ten-year recognition period to seven years (if that seventh year precedes either 2009 or 2010). This result is generally unfavorable, so the benefits of the pass-through need to be weighed against the immediate issue of built-in gain. A certified public accountant can help make this determination.
LIFO Inventories. 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. Again, this cost must be weighed against the potential tax gains from converting to S status. The result will depend on a number of factors.
Unused Losses. If a 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.
Passive Income. S corporations that were 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 percent 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 will be terminated. One can avoid the tax by distributing the earnings and profits, which would be taxable to shareholders. Or, you can avoid the tax by avoiding recognition of passive income. This takes multiple years of tax planning and highlights that some businesses are more suited for a conversion than others.
Another key difference for corporations that have a number of employees is that shareholders/employees of S corporations can't get the full range of tax-free fringe benefits that are available with a C corporation. Whether or not to make the conversion is a fact-specific exercise that depends upon your company's particular circumstances. Consult with an attorney experienced in tax issues to discuss the effect of these and other potential problems, and possible strategies for dealing with them.