How to Convert a C Corp to an S Corp: Key Steps & ESOP Insights

Converting from a C corporation to an S corporation can reduce double taxation and, for ESOP-owned companies, unlock powerful pass-through advantages, but it’s not a “one-click” move, and both the decision and the process can be complex.

Timing, eligibility, the five-year built-in gains (BIG) window, and 409(p) testing all matter. The right answer depends on your ESOP ownership percentage, your transaction roadmap, and your goals — which is why we start with a feasibility study and coordinate closely with your CPA, ERISA counsel, and trusted business advisors.

In this article, we walk through the conversion steps, key technical considerations, and ESOP-centric issues you must address.

S-Corp or C-Corp for Your ESOP? It Depends on Ownership Level

Major benefit: The portion of your company owned by the ESOP doesn’t pay corporate taxes. So a 100% ESOP-owned company pays zero federal income tax. This frees up cash for growth and buying out shareholders.

The catch with S-corps: If your ESOP owns less than 100% of the company, the other shareholders will owe personal taxes on their share of profits. They’ll need cash distributions to pay those taxes. But here’s the rub: If you distribute cash to them, you must also distribute proportionally to the ESOP, which can lead to overfunding.

Rule of thumb from a feasibility perspective:

• Small ESOP (under 50%)? C-Corp structure often works better
• Large ESOP (approaching 100%)? S-Corp structure typically makes more sense
• In between? Run the numbers with your advisors

Bottom line: Don’t assume S-Corp is always better simply because it’s tax-free. With a minority ESOP, the forced cash distributions can actually create new problems. Talk to your ESOP advisors about modeling both scenarios for your specific situation.

Step 1: Feasibility first (and why)

At ESOP Partners, the journey begins with an ESOP feasibility study to quantify tax liabilities, cash flow, repurchase obligations, and governance under both C and S scenarios. 

This identifies your business’s unique “tipping point” where an S-election adds value — especially if you plan to sell in increments over time. It’s a nuanced evaluation, so our experts quarterback the process and bring clients’ CPAs, attorneys, lenders, and business advisors in to get the right questions asked and answered at the right time.

What we evaluate together:

• Ownership % path (single close vs. staged sales)
• Distribution dynamics in an S corp (to avoid ESOP overfunding)
• 409(p) exposure if you convert to S (see below)
• Built-in gains (BIG) modeling for appreciated assets if/when you elect S
• 1042 objectives (may require C status before a sale)

Step 2: Pre-Election Cleanup Checklist

Before filing the S election (Form 2553), coordinate with your CPA/attorney on:

1. Check for disqualified shareholders or entities: Verify all shareholders are eligible S corp shareholders (no ineligible trusts, partnerships, nonresident aliens).
2. Audit of assets, liabilities, and basis: A full balance sheet review is needed to capture any hidden liabilities or disqualified assets.
3. LIFO recapture (if applicable): If the company has been using LIFO inventory accounting, conversion triggers §1363(d) recapture (income inclusion) to unwind LIFO reserves.
4. Clean up E&P/AAA tracking: As a former C, the company must track Accumulated Adjustments Account (AAA) and Earnings & Profits (E&P) to manage distributions properly.
5. Model BIG exposure: Simulate built-in gains tax (discussed in the companion article) for any appreciated assets you might sell in the early years.
6. Review synthetic equity/option plans: Any option, warrant, or convertible debt must be scrutinized under 409(p) (see below).
7. Election timing:  A mid-year election can help align tax status with an ESOP transaction closing date — but it can also complicate BIG modeling, 409(p) testing, and repurchase cash flow forecasts. Ask your ESOP and tax advisors to run side-by-side models for both half-years before electing.

Step 3: Filing the S Election

Use IRS Form 2553, ensuring the filing meets signature, deadline, and shareholder consent rules. The BIG clock starts on the first day of S corporation status. Form 2553 can be filed up to two months and 15 days after the intended effective date.

The election is typically effective at the start of a tax year (see the above note about mid-year elections). In some cases, late election relief may be available if certain conditions are met

Once the S election is effective, the corporation transitions from C to S tax rules — but it carries residual baggage from its past as a C corp,  including built-in gain exposure and compliance with 409(p).

How Long After Converting to an S Corp Does the BIG Tax Apply?

Built-in gains tax applies for 5 years from the first day of S-corp status under IRC §1374.

After You Convert: Two Critical ESOP-Specific Rules

Built-in Gains (BIG) Exposure

If appreciated assets held at conversion are sold within five years, a corporate-level BIG tax can apply (at the highest corporate rate) on the lesser of the year’s recognized gain or remaining net unrealized built-in gain (NUBIG). The tax is computed at the highest corporate rate per IRC §1374.

The risk is material; don’t “start the clock” until your roadmap is modeled.

409(p) Anti-Abuse Rules for S-ESOPs

Because S-ESOPs offer powerful tax benefits, Congress added §409(p) to prevent abusive concentration of benefits.

• The central test is an ownership concentration rule: No portion of ESOP stock may accrue or be allocated during a “nonallocation year” if disqualified persons (DQP) collectively own ≥ 50% (directly or via synthetic equity)
• Disqualified persons generally include those who own ≥10% of ESOP shares (or including family aggregation). Also includes synthetic equity instruments (warrants, options)
• Violations can carry severe consequences: Deemed distributions taxed to the DQPs, excise taxes, potential plan disqualification, or loss of S status
• There is no safe harbor correction path for many violations, so prevention is essential

Sometimes, Staying a C Corp Makes More Sense

Converting to an S-Corp isn’t always the right move, and timing matters. These situations demonstrate why it’s so important to run the numbers first.

You’re planning to sell major assets soon. If you're sitting on buildings, equipment, or other appreciated assets you plan to sell, the BIG tax can wipe out the S-corp advantage.

Your selling shareholder wants to defer capital gains. Section 1042 is a powerful tax deferral tool, but it only works in C-Corps. If this is part of your exit strategy, converting too early could be costly.

You have valuable tax losses or credits. Sometimes, C-Corp status lets you use these more effectively. Don’t leave money on the table by converting prematurely.

Think of this as a “measure twice, cut once” situation. A few hours of planning now can save the selling shareholder six or seven figures in unnecessary taxes later.

Summary / Best Practices Checklist for Conversion

Make Your ESOP Transition Work Harder

Converting from a C corporation to an S corporation, especially with an ESOP in place, can unlock powerful cash-flow and tax benefits. The team at ESOP Partners is here to walk through your numbers and help you determine the right structure and timing for your goals. We’ll model C vs. S outcomes side-by-side, align your advisory team, and help you time decisions for maximum value. Just reach out with your questions.

In the meantime, learn more about the ways employee ownership impacts key leadership and management decisions. Download your copy by clicking below.