The best choice of business entity can affect your business in several ways, including the amount of your tax bill. In some cases, businesses decide to switch from one entity type to another. S corporations are know to provide provide substantial tax benefits over C corporations in some circumstances. However, there are potentially costly tax issues that you should assess before making the decision to convert from a C corporation to an S corporation.

Here are four issues to consider for an S Corp vs C Corp:

1. LIFO Inventories

Do you currently have a C corporations and use the last-in, first-out (LIFO) inventory management strategy? If so, you must pay tax on the benefits derived by using LIFO after converting 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.

2. Built-In Gains Tax

S corporations generally aren’t subject to tax. However, those that were formerly C corporations are taxed on built-in gains (such as appreciated property) that the C corporation has when the S election becomes effective. This is applicable if those gains are recognized within five years after the conversion. This is generally unfavorable, although there are situations where the S election still can produce a better tax result despite the built-in gains tax.

3. Passive Income

S corporation requirements include a special tax if the business was formerly a C corporations. It kicks in if their passive investment income (including 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 accumulated earnings and profits, which would be taxable to shareholders. Or you might want to avoid the tax by limiting the amount of passive income.

4. Unused Losses

If your C corporation has unused net operating losses, they 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.

Other Considerations

When a business switches from C to S status, these are only some of the factors to consider. For example, shareholder-employees of S corporations can’t get all of the tax-free fringe benefits that are available with a C corporation. And there may be issues for shareholders who have outstanding loans from their qualified plans. Consideration of these factors are to understand the implications of converting from C to S status.

If you’re considering in an entity conversion, contact us. Our accounting firm can help. We can help explain all your options, how each option affects your tax bill. In addition, we can also provide possible strategies that you can use to minimize taxes.