Limitations of Switching a C-Corporation to an S-Corporation

by John Cromwell

    An S corporation is a type of corporation created by a tax election with the IRS. To become an S corp, a business must first incorporate as a regular corporation, or C corp, and then elect S-corp status. A C corp can generally make the S-corp election at any time. However, the corporation must balance the tax benefits of becoming an S corp against other factors.

    Differences in Tax Treatment

    The key advantage of an S corporation over a standard corporation is that S-corp revenues are only taxed once. An S corp's revenues are divided amongst its shareholders, who then report their shares of the income on their personal returns and pay taxes on those amounts. A C corp pays taxes on its income as it's earned at the corporate level -- and then the shareholders pay taxes on that income when they receive it as dividends.

    Limitations on Raising Capital

    One of the chief reasons a business chooses to form a C corp is to make it easier to obtain outside investment. If a C corp chooses to convert to an S corp, its ability to obtain outside investment is greatly diminished. S corporations can only have 100 shareholders or less, none of which can be partnerships, corporations or non-resident aliens. This means that S-corp stock cannot be sold to venture capitalists or on public exchanges. The IRS also limits an S corp to one class of stock, so that each share has the same rights to distributions and liquidation proceeds. This prevents an S corp from incentivizing individuals to invest by offering shares that have a preferred claim on the business's assets, a common tactic used by C corps.

    Limited Business

    An S corporation must be domestic, which means that it must either be headquartered in the United States, or eligible for treatment as a company headquartered in the United States. Banks, insurance companies, possessions corporations, or current or former domestic international sales corporations cannot elect S-corp status.

    Process of Switching

    For a C corporation to switch to an S corporation, all its shareholders must agree to the election. Since the transition to an S corp would limit the ability of the current shareholders to sell their shares due to the IRS's ownership restrictions, getting the necessary approval could be costly and time-consuming.

    Passive Income Basics

    If a C corp converts to an S corp, and the business still has accumulated earnings and profits, the S corp is limited as to how much passive income it may earn. Accumulated earnings refer to income that the business obtained as a C corp and did not distribute to its shareholders as dividends prior to the S-corp conversion. Passive income is revenue that a business earns from activities in which it does not actively participate, such as income from interest, rents, royalties, and stock sale gain.

    Passive Income and Tax Status

    If a converted S corp still has accumulated earnings and more than 25 percent of its revenue is passive income, the excess passive income is taxed at the highest corporate tax rate. If the S corp's passive income accounts for more than 25 percent of its total revenues for three straight years, the business loses its tax status. The business can avoid this problem by distributing all its accumulated earnings prior to converting to an S corp. However, the taxpayers would have to pay tax on those dividends.

    Net Operating Losses

    Sometimes a C corp can sustain net operating losses that it can use to offset future taxable income. This can represent significant future savings. However, if the C corp converts to an S corp, any available deductible losses are lost; the S corp cannot use them and the losses are not passed through to the S corp's shareholders. Therefore, a C corp should compare the tax benefits of an S-corp election with the tax savings from its net operating losses.

    About the Author

    John Cromwell specializes in financial, legal and small business issues. Cromwell holds a bachelor's and master's degree in accounting, as well as a Juris Doctor. He is currently a co-founder of two businesses.