How to Change Corporation Status From C to S

A business structured as a C corporation is a distinct legal entity separate from its owners, which results in its profits being taxed at the corporate level. When those profits are distributed to shareholders as dividends, they are taxed again on the shareholders’ personal returns, a system often referred to as double taxation. An S corporation, by contrast, is a tax classification that allows income, losses, deductions, and credits to pass through directly to the shareholders’ personal tax returns, avoiding federal tax at the corporate level.

This pass-through structure is a primary motivator for businesses to change their status. The process requires a company to meet strict eligibility criteria and follow precise procedural steps mandated by the Internal Revenue Service (IRS).

S Corporation Eligibility Requirements

Before a corporation can elect S corporation tax status, it must satisfy a specific set of requirements outlined by the IRS.

• It must be a domestic corporation, meaning it was formed and organized under the laws of the United States.
• It can have no more than 100 shareholders. For this purpose, members of a family can be treated as a single shareholder.
• Eligible shareholders are generally limited to individuals who are U.S. citizens or residents, certain types of trusts, and estates. Partnerships, other corporations, and non-resident aliens are explicitly prohibited from owning shares.
• It is permitted to have only one class of stock, meaning all shares must confer identical rights to distribution and liquidation proceeds. The corporation can, however, have differences in voting rights among its shares, allowing for voting and non-voting common stock.

Preparing and Completing Form 2553

The process of changing from a C corporation to an S corporation is initiated by filing Form 2553, Election by a Small Business Corporation, with the IRS. This form requires detailed information about the corporation and its owners.

Part I of Form 2553, titled Election Information, captures the corporation’s legal name, mailing address, and Employer Identification Number (EIN). The form also requires the date of incorporation, the state where it was formed, and the specific date the S corporation election is to become effective. You must also select the corporation’s tax year, which is often a calendar year.

Part II of the form is the Shareholders’ Consent Statement, a mandatory component demonstrating that all owners approve of the election. Every individual who is a shareholder on the day the election is made must sign and consent to the change. For each shareholder, you must provide their name and address, their signature, the number of shares they own, and the date they acquired those shares.

An incomplete or improperly signed consent statement is a common reason for the IRS to reject the election. If shares are owned jointly, such as by a married couple, both individuals may need to sign.

Filing Procedures and Deadlines

Once Form 2553 is completed and signed, it must be filed with the IRS according to strict deadlines. The primary window for filing is no more than two months and 15 days after the beginning of the tax year in which the election is intended to take effect. For a corporation using a calendar year, this means the form must be filed by March 15. A corporation can also file Form 2553 at any time during the preceding tax year.

The completed Form 2553 must be mailed or faxed to the correct IRS service center. The appropriate address or fax number depends on the state where the corporation’s principal business or main office is located. These addresses are provided in the Instructions for Form 2553.

After submitting the form, the corporation should wait for official correspondence from the IRS. If the election is accepted, the IRS will send a notification letter, often a CP261 notice, confirming the S corporation status and the effective date. This notification typically arrives within 60 to 90 days of filing. If no notification is received, the corporation should contact the IRS.

In situations where a corporation misses the filing deadline, relief may be available. Revenue Procedure 2013-30 provides a simplified method for certain corporations to obtain relief for a late S corporation election. To qualify, the corporation must have a reasonable cause for its failure to file on time and must file Form 2553 within 3 years and 75 days of the intended effective date, attaching a statement explaining the reasonable cause.

Understanding the Built-In Gains Tax

A significant financial consequence of converting from a C corporation to an S corporation is the Built-In Gains (BIG) tax. This is a corporate-level tax imposed directly on the S corporation to prevent companies from avoiding corporate-level tax on appreciated assets by converting to a pass-through S corporation and then immediately selling those assets.

The tax applies to gains from assets sold within a five-year “recognition period” following the date the S corporation election takes effect. The taxable gain is the amount by which an asset’s fair market value exceeded its adjusted basis on the first day of the S corporation’s first tax year. Any appreciation that occurs after the conversion date is not subject to the BIG tax and is treated as a normal pass-through gain to the shareholders.

The BIG tax is calculated using the highest corporate income tax rate, which is currently 21%. To illustrate, a C corporation converts to an S corporation owning real estate with an adjusted basis of $200,000 and a fair market value of $500,000, resulting in a built-in gain of $300,000. If the S corporation sells that property two years later for $550,000, the BIG tax would apply to the initial $300,000 of built-in gain. The tax liability would be $63,000 ($300,000 x 21%). The remaining $50,000 of appreciation would be passed through to the shareholders.

Properly determining the fair market value of all corporate assets on the conversion date is an important step in managing this tax. This often requires a formal appraisal of assets like real estate, machinery, and intellectual property.

Additional Tax Considerations After Conversion

Other specific tax implications can arise when a C corporation converts to an S corporation.

LIFO Recapture Tax

This tax applies if the C corporation used the Last-In, First-Out (LIFO) method of accounting for its inventory. The LIFO recapture amount is the difference between the inventory’s value under the First-In, First-Out (FIFO) method and its value under LIFO at the close of the corporation’s final year as a C corporation. This amount must be included in the C corporation’s gross income for its last tax year, and the resulting tax is paid in four equal annual installments.

Passive Investment Income Tax

This tax can affect an S corporation that has accumulated earnings and profits from its time as a C corporation. If such an S corporation’s passive investment income—which includes sources like royalties, rents, dividends, and interest—exceeds 25% of its gross receipts for a given year, a tax is imposed at the highest corporate rate on the excess net passive income.