The right choice of a business entity can make a difference in the tax bill you owe for your business. Yes, it is true that S corporations can provide substantial tax advantages over C corporations in some circumstances. However, there are plenty of potentially expensive tax problems that you should assess between an S Corp vs C Corp before making the decision to changing entities.
Here’s a quick rundown of four issues to consider:
C corporations that use last-in, first-out (LIFO) inventories must pay tax on the benefits they derived by using LIFO if they convert 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.
Although S corporations generally aren’t subject to tax, 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, 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.
When looking at an S Corp vs C Corp, S corporations that were formerly C corporations are subject to a special tax. That tax kicks in if their passive investment income exceeds 25% of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. This includes dividends, interest, rents, royalties, and stock sale gains. 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.
Does your C corporation have any unused net operating losses? If so, these losses are not usable to offset its income as an S corporation. In addition, these losses are not passable through to shareholders. If you can’t carry these losses back to an earlier C corporation year, it will be necessary to weigh the cost of giving up the losses against the tax savings that you are expecting to generate by switching to the S status.
These are only some of the factors to consider when a business switches from C to S status. For example, when looking at an S Corp vs C Corp, the tax-free fringe benefits differ for shareholder-employees. In an S corporation, employees can’t get all of the tax-free fringe benefits that are available with a C corporation. In addition, there may be issues for shareholders who have outstanding loans from their qualified plans. You need to take each of these factors into account. Doing so will help better understand the implications of converting from C to S status.
Contact us. We can explain how these factors will affect your company’s situation and come up with the best business structure to minimize taxes.