The Process of Changing From an S Corp to a C Corp

An S corporation provides pass-through taxation, where profits and losses are reported on the owners’ personal tax returns. A C corporation is a distinct taxable entity, paying taxes at the corporate level, with shareholders also paying taxes on dividends received. When a business’s strategic goals shift, converting from an S corp to a C corp is a significant structural change with several implications.

Key Considerations for Revoking S Corp Status

A reason for changing from an S corp to a C corp relates to the company’s capital structure. S corporations are restricted to a single class of stock, meaning all shares must have identical rights to distribution and liquidation proceeds. This can limit a company’s ability to attract investors who require different terms. Converting to a C corporation removes this barrier, permitting multiple stock classes, such as preferred stock, to entice venture capital and other institutional funders.

Shareholder eligibility rules for S corporations are another constraint. An S corp cannot have more than 100 shareholders, and all must be individuals who are U.S. citizens or residents, or certain types of trusts and estates. This excludes corporations, partnerships, and foreign investors from owning stock. For a business aiming for an initial public offering (IPO) or seeking investment from a diverse pool, these limitations make a conversion to a C corp necessary.

Analyzing potential tax rate differences is part of the decision. The pass-through nature of an S corp means shareholders are taxed on their portion of the company’s net profit, regardless of whether that cash is distributed. In contrast, a C corporation pays a corporate income tax on its profits, and shareholders are only taxed on dividends they receive. Depending on the corporation’s profitability and the individual tax brackets of its shareholders, the combined C corp tax could be more favorable.

The tax treatment of fringe benefits for owners also differs. C corporations can provide tax-deductible fringe benefits to their shareholder-employees, including health and disability insurance plans. For S corporations, a shareholder who owns more than 2% of the company’s stock is treated like a partner, meaning the value of such benefits is included in their taxable income. This distinction can make the C corp structure more appealing for offering comprehensive compensation packages.

Preparing the Revocation Statement

To initiate the change, the business must prepare a formal revocation statement to file with the Internal Revenue Service (IRS). This is a formal letter, not a specific IRS form. The statement must contain the corporation’s full legal name, its current mailing address, and its Employer Identification Number (EIN).

The letter must declare that the corporation is revoking its election under Internal Revenue Code Section 1362. The corporation must also specify the effective date of the revocation. If the revocation is filed by the 15th day of the third month of the corporation’s tax year, it can be effective as of the first day of that year. If filed after that deadline, the revocation becomes effective on the first day of the following tax year, unless a prospective date is specified.

The revocation requires the approval of shareholders who hold more than 50% of the corporation’s total shares, including non-voting stock. A separate consent statement must be attached to the revocation letter. This attachment should list the name, address, and taxpayer identification number for each consenting shareholder, the number of shares they own, the dates they acquired them, and their signature.

Submitting the Revocation to the IRS

The revocation statement and shareholder consent document must be mailed to the same IRS service center where the corporation files its annual tax return. The mailing addresses for these service centers are on the IRS website and vary by the corporation’s location. It is advisable to send the package via a method that provides proof of delivery.

After the IRS processes the revocation, it will issue a confirmation letter. This letter acknowledges that the S corporation election has been terminated and confirms the effective date of the change. The corporation should retain this confirmation letter as a permanent part of its corporate records for future tax filings and to demonstrate its tax status.

Tax Consequences of the Termination

The primary consequence of converting is a shift to a two-tiered tax structure. The C corporation pays corporate income tax on its taxable income, reported on Form 1120, U.S. Corporation Income Tax Return. When the corporation distributes its after-tax profits as dividends, those shareholders must pay personal income tax on the amounts they receive.

A significant tax consideration is the Built-In Gains (BIG) Tax. This tax is designed to prevent companies from avoiding tax by switching from an S corp to a C corp before selling appreciated assets. If an asset that increased in value during the S corp years is sold by the new C corp within a 5-year recognition period, the corporation must pay tax on that built-in gain at the highest corporate tax rate.

Undistributed profits from the S corp period are tracked in an Accumulated Adjustments Account (AAA). The tax code provides a Post-Termination Transition Period (PTTP), which extends for one year after the S corp status ends. During the PTTP, the corporation can make distributions to shareholders from the AAA balance tax-free, to the extent of their stock basis. This allows shareholders to withdraw S corp earnings without them being treated as taxable C corp dividends.

The conversion necessitates a change in tax return filing. The corporation must file a final, short-year S corporation tax return (Form 1120-S) for the tax period ending the day before the revocation becomes effective. For the remainder of the year, the corporation will file its first C corporation tax return using Form 1120. For example, a calendar-year S corp revoking its status effective July 1 would file a Form 1120-S for January 1 through June 30 and a Form 1120 for July 1 through December 31.