Converting an S Corp to a C Corp: The Process

An S corporation (S corp) and a C corporation (C corp) are business structures separated by their approach to federal taxation. An S corp is a pass-through entity, meaning its profits and losses are passed to the shareholders’ personal tax returns, avoiding income tax at the corporate level. In contrast, a C corp is taxed as a separate entity and its shareholders are taxed again on dividends, a system known as double taxation.

Deciding to convert from an S corp to a C corp is a strategic move. This change alters how the business is taxed and is often done to align the company’s legal and tax framework with its long-term objectives for ownership structure and growth.

Key Considerations for Conversion

A primary driver for converting to a C corp is the ability to attract investment capital. Venture capitalists and institutional investors prefer the C corp structure because it allows for the issuance of multiple classes of stock, such as preferred stock. This flexibility, which S corps cannot offer due to their single-class-of-stock limitation, makes C corps more suitable for securing equity financing.

The restrictive shareholder rules of an S corp also motivate conversion. An S corp is limited to 100 shareholders, who must be U.S. citizens or residents, a ceiling that can be a barrier for a growing company. Converting to a C corp eliminates these constraints, permitting an unlimited number of shareholders of any type, including corporations, partnerships, and foreign investors.

The applicable tax rates are another consideration. A C corp is subject to a flat 21% federal corporate tax rate, while S corp income is taxed at individual rates as high as 37%. For a profitable business that reinvests a substantial portion of its earnings, the C corp’s flat tax rate could result in a lower immediate tax bill.

C corps can also offer a wider array of tax-deductible fringe benefits. C corps can generally deduct the full cost of health insurance premiums for owner-employees, and these benefits are received tax-free. For S corps, these same benefits for shareholders who own more than 2% of the company are often treated as taxable income.

Required Information and Documentation

Before a conversion can be initiated, the decision must be authorized by shareholders who hold more than 50% of the corporation’s outstanding stock. This shareholder vote should be documented in the official corporate minutes, creating a permanent record of the authorization.

The central document for this change is the revocation statement filed with the Internal Revenue Service (IRS). This statement must include the corporation’s legal name, mailing address, and its Employer Identification Number (EIN). The document must also feature a declaration that the corporation is revoking its S corporation election.

Further details required in the revocation statement include the desired effective date of the change and the total number of stock shares issued and outstanding. The document must be signed by the consenting shareholders, with their names and titles printed, alongside the number of shares each owns.

A corporation must also address any obligations at the state level. Each state has its own rules for recognizing a change in tax status, which may involve filing a specific form or submitting a notification through an online business portal.

The Conversion Process

Once the shareholder-approved revocation statement is prepared, it must be filed with the IRS service center that handles filings for the state where the corporation’s business is located. The timing of this filing determines when the conversion becomes effective.

To have the revocation take effect for the current tax year, the statement must be filed by the 15th day of the third month of that tax year. A statement filed after this deadline will make the conversion effective at the start of the following tax year.

After submitting the revocation statement, the corporation should anticipate official correspondence. The IRS will send a confirmation letter acknowledging that the S election has been successfully revoked and noting the effective date of the change. From that date, the company is legally a C corp and must operate in compliance with all applicable regulations.

Tax and Accounting Consequences

The conversion from an S corp to a C corp triggers changes in tax reporting and accounting. The company must file a final, short-year S corp tax return, which covers the period from the beginning of the tax year up to the day before the conversion’s effective date. This filing officially closes the books on the company’s time as a pass-through entity.

Following the conversion, the new C corp must file its first corporate income tax return. This initial return will cover the period starting from the effective date of the conversion through the end of the corporation’s chosen tax year, marking the beginning of the company’s obligation to pay corporate income tax.

A consideration is the Built-In Gains (BIG) tax. If the C corp sells assets within a five-year recognition period after conversion that had appreciated in value while it was an S corp, it may owe this tax. The BIG tax is imposed at the highest corporate tax rate on the gain that existed at the time of conversion.

Shareholders must address the Accumulated Adjustments Account (AAA), which tracks earnings already taxed to shareholders during the S corp years but not yet distributed. There is a post-termination transition period during which these funds can be distributed to shareholders tax-free. Any distributions from the AAA after this period may be treated as taxable dividends.

Shareholder-level losses that were suspended during the S corp years are generally frozen at the time of conversion. These suspended losses may become deductible during the post-termination transition period if the shareholder increases their stock basis.

Stock issued by the company after it becomes a C corp may be eligible for Qualified Small Business Stock (QSBS) treatment, provided certain conditions are met. This can offer a benefit to investors, as it allows for a potential 100% exclusion of capital gains from federal tax upon the sale of the stock.