Tax Consequences of Converting a C-Corp to an S-Corp

By Mike Keenan

Corporations are business entities formed under state law that exist separately from their owners. An S corporation is simply a C corporation that has elected to be taxed as a pass through entity. Converting from a C-corp to an S-corp has significant tax implications, which include potentially lowering the overall tax burden on the shareholders, but also changing who reports the income each year and limiting when the income can be reported on the shareholder's tax returns. However, an S-corp must meet several criteria, including having less than 100 owners, only having U.S. resident or U.S. citizen individuals and certain entities as shareholders, and not having more than one class of stock.

Pass Through Taxation

A C-corp is taxed at the entity level while an S-corp is taxed at the individual level. Pass through taxation means that the income and losses from an entity is not taxable to the entity, but rather is reported on the tax returns of the owners of the entity. With a C-corp, the company's income or losses are reported on the corporate income tax return. Only when the company pays out its earnings to the shareholders do the shareholders report any income on their tax returns. When you convert a C-corp to an S-corp, the business income no longer gets taxed to the corporation. Instead, the income passes through to the shareholders of the S-corp and gets included on the shareholders' personal returns. This also allows shareholders to take corporate losses on their personal tax return.

Double Taxation

Because an S-corp is a pass through entity, it avoids double taxation. When a C-corp has profits, the corporation is taxed on those profits at corporate rates. Then, when the corporation makes distributions to the shareholders, the money is taxed a second time as a dividend on the shareholders' returns. After converting to an S-corp the company is no longer subject to the corporate income tax. Instead, shareholders report the income or losses on their own tax return so the money isn't taxed twice.

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Distributions

A C-corp must report all of its income or losses each year on the corporate income tax return. However, a C-corp does not have to pay out any of its earnings to the shareholders, so if the company doesn't make any distributions, shareholders don't have any income to report on their income taxes. With an S-corp, the income or losses pass through to the shareholders every year whether or not the company actually makes distributions. For example, if the company earns $10,000, the shareholders must report that income even if the S-corp doesn't distribute any of the income.

Tax Rates

The corporate income tax rates are different than the personal income tax rates. A C-corp is taxed at the corporate tax rate while S-corp income is taxed at the individual tax rate. If the individual tax rate is lower than the corporate tax rate, this results in tax savings the business income. For example, if the applicable corporate tax rate is 35 percent and the applicable individual rate is only 28 percent, the business income would be taxed at a lower rate after converting from a C-corp to an S-corp.

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S Corp Vs. Corp

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Subchapter S Corporation Stock Regulations

S corporations are ideal for companies with few owners who would rather report the income on their own tax returns rather than have the company pay the corporate tax. However, S corporations s have strict regulations on the stock issued by the company. Just one violation can trigger a reversion to a C corporation, thereby nullifying the tax benefits granted to an S corp.

Switching Ownership of the S Corp

An S corporation begins its life as a regular corporation. At some point after creation, the corporation makes a Subchapter S election with the Internal Revenue Service for special tax treatment. To be approved, the corporation must meet the IRS eligibility requirements. S corporations remain subject to the laws of the state as they apply to all corporations, including laws on transfers of ownership. If the change in ownership destroys its IRS eligibility, the corporation will automatically lose its S corporation status.

S-Corporation Tax Write Offs for Losses

An S corporation is a small corporation that meets certain criteria and has made an election with the IRS to be treated as a disregarded entity for tax purposes. Instead of paying taxes at the corporate level, the S corp's losses and profits are passed through to shareholders, who pay the taxes. This has various tax advantages for owners, whether the company has a profitable tax year or shows a loss on its corporate tax return.

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