As an owner of a closely held company, unless you elected S corporation status, it’s likely your business is currently a C corporation. Maybe your tax professional has brought up the idea of converting from a C corp to an S corp.
What’s the difference? A C corporation is taxed under subchapter C of the Internal Revenue Code, and an S corporation gets its name from subchapter S.
While a potential savings on taxes is the primary reason many companies elect S corp status, that tax benefit can have a ripple effect that affects the business, owners, and employees. It’s possible that an S corporation’s tax efficiency can help some companies drive operational and performance improvements.
Business owners investigating and planning their future exit strategies may have special considerations when exploring whether to elect S corp status—and the conversion to an S corp can take some careful planning and the guidance of a tax professional.
Here are the main factors to consider:
- C corporation earnings are double taxed.
- As a pass-through entity, an S corp is generally exempt from taxes, and instead passes tax responsibility through to shareholders.
- Built-in gains (BIG) tax is one exception to the federal tax exemption for S corps.
- The recognition period for the conversion from C corp to S corp is five years, and there are limits to converting back to C corp status.
- Passive income inherited by S corps from C corps can also be subject to tax—and in some cases can terminate S corp status.
- An S corporation can’t inherit operating losses from a C corporation to pass through to shareholders for deduction.
- S corps can’t use last-in, first-out (LIFO) as an inventory valuation method, and if the C corp is using it at S corp election, a tax is imposed.
- Not all C corps are eligible for S corp conversion, and restrictions exist on who can own S corp shares.
- For business owners selling to an ESOP, differences between a C corp and an S corp can be significant.
1. A C corporation’s earnings are double taxed.
C corps are taxable entities, so they file a corporate return (Form 1120) and pay taxes at the corporate rate. Then, from that taxed income, there may be profits that are distributed as dividends to shareholders. That distributed income is taxed at the individual level as personal income.
2. S corps are generally exempt from taxes, but shareholders are not.
The same is true with regard to most state income taxes. An S corp is a pass-through entity. While it files an informational return (Form 1120S), it does not pay income tax at the corporate level (with few exceptions). But that doesn’t mean taxes won’t be paid on profits. Rather, profits and/or losses are passed through to the business owner or shareholders, who pay individual income taxes.
|An Employee Stock Ownership Plan (ESOP) trust counts as a single shareholder, regardless of the number of ESOP participants, and because an ESOP is a qualified benefit plan, a 100% ESOP-owned S corporation is a tax-exempt entity. That means there is no need for the shareholder to pay taxes on distributions. For ESOPs that own less than 100% of an S corp, tax benefits are proportional to the percentage owned by the ESOP trust.
3. Built-in gains (BIG) tax may be owed after C corp to S corp conversion.
One significant potential federal tax consequence is the BIG tax. If an S corp inherits assets after conversion from a C corp and sells those assets within five years, it will be subject to built-in gains tax on the asset sale, in addition to taxes paid by shareholders on any income they would receive through dividends.
4. Conversions have a five-year recognition period.
If a business owner converts from a C corp to an S corp and the company waits five years to sell appreciated assets, BIG tax can be avoided. Instead, gains passed through to shareholders are taxed at the individual shareholder level. When an S corp is terminated and becomes a C corporation, the company won’t have the option to elect S corp status again for a five-year period.
5. An S corp’s inherited passive income can be subject to tax.
After conversion from a C corp, an S corporation can inherit income such as rent, interest, retained earnings, funds derived from stock sales, etc. Passive income that makes up more than 25% of an S corp’s gross income is subject to tax. S corps with more than 25% of their gross income as passive income for three consecutive tax years may have their S corp status terminated.
6. An S corp’s inherited operating losses can’t be passed through to shareholders.
Unlike normal operating losses, which can be passed through to S corp owners for deduction, inherited losses from the previous C corp can’t be carried forward and passed through. If there are net operating loss carryforwards, they can’t be used by the S corp. A C corp may file amended carryback returns during the five-year recognition period.
7. S corps can’t use the last-in, first-out (LIFO) inventory valuation method.
The process of LIFO recapture, described in Section 1363(d), prevents S corps from avoiding the BIG tax by using the LIFO method of inventory valuation. At conversion, the difference between inventory value under LIFO valuation and lower-of-cost-or-market (LCM) valuation is generally included in the C corp’s final tax return. The tax attributed to LIFO recapture is payable in four installments.
8. Not all C corps can become S corps, and there are restrictions on S corp stock.
C corps with more than 100 shareholders are not eligible for conversion to an S corp, and neither are corporations that issue more than one class of shares. Certain types of financial institutions and insurance companies are not eligible for S corp status, and neither are domestic international sales corporations (DISCs) or former DISCs. Certain types of shareholders are ineligible for S corp stock ownership, including foreign shareholders and certain trusts.
9. A business owner selling to an ESOP should consider the differences between C corp and S corp.
The owner of a closely held business who has decided to sell to an ESOP as part of a succession plan and exit strategy can expect some significant differences between selling an S corp and a C corp. A C corp owner may be able to defer (and possibly avoid) capital gains tax on the sale by meeting several specific requirements.
Under Section 409(p), ESOP-owned S corps are subject to anti-abuse laws. ESOP-owned C corporations aren’t subject to those provisions.
Weigh the Pros and Cons Before Conversion
Any change to a business tax status can have unintended consequences, both positive and negative. It’s smart business practice to consult with a tax professional before making the decision. No single choice is right for every organization.
For those owners of closely held corporations considering their exit strategy, it’s never too soon to explore whether selling to an ESOP might be the right choice. An ESOP sale creates a buyer—an ESOP trust—which purchases the company at fair market value. Plus, an ESOP offers flexibility in structuring the transaction, a controlled exit for the seller, and a way to maintain the company’s brand identity, leadership, and culture for the long term.
Discover whether your business might be a good fit for an ESOP sale when you take our quick and easy quiz. Click below and find out today!