What Happens to C Corp Retained Earnings When Converting to S Corp?

Businesses often operate as either C corporations or S corporations, two distinct legal structures with differing tax treatments. A C corporation is taxed as a separate entity, with profits taxed at the corporate level and again when distributed as dividends. An S corporation, conversely, is a pass-through entity, where profits and losses pass directly to owners’ personal income without corporate-level tax. Companies may convert between these structures for various reasons, often for tax advantages. When a C corporation transitions to an S corporation, the treatment of its accumulated profits, or retained earnings, becomes a significant concern, as this conversion can trigger specific tax consequences related to these earnings and the company’s asset value.

Understanding C Corporation Earnings and Profits

C corporations are subject to corporate-level income tax on their profits. After paying expenses and taxes, remaining income can be distributed or retained. These retained funds are recorded as retained earnings for financial accounting. For tax purposes, “Earnings and Profits” (E&P) tracks a C corporation’s capacity to make taxable dividend distributions to shareholders.

E&P is a tax-specific measure, not always identical to financial accounting retained earnings, representing the corporation’s economic ability to pay dividends. E&P increases with taxable income, certain tax-exempt income, and other items that increase economic wealth. Conversely, E&P decreases with distributions, certain non-deductible expenses, and corporate losses.

E&P’s significance for a C corporation lies in determining the taxability of distributions to shareholders. Distributions are treated as taxable dividends to the extent of the corporation’s E&P. Any distributions exceeding E&P are considered a tax-free return of capital up to a shareholder’s stock basis, then as capital gains. This E&P concept is central to the “double taxation” characteristic of C corporations.

Treatment of Earnings and Profits Post-Conversion

When a C corporation converts to an S corporation, any accumulated Earnings and Profits (E&P) from its C corporation years do not disappear. These accumulated E&P (AE&P) are carried over to the S corporation. This means the S corporation inherits the potential for distributions to be taxed as dividends to shareholders, despite its pass-through nature. The presence of AE&P in an S corporation necessitates the maintenance of an “Accumulated Adjustments Account” (AAA).

The AAA is a unique S corporation account that tracks the cumulative taxable income and losses of the S corporation that have already been passed through and taxed to its shareholders. AAA increases with S corporation income (excluding tax-exempt income) and decreases with S corporation losses and distributions. This account ensures shareholders do not pay tax twice on the same income.

Distributions from an S corporation with AE&P are subject to specific ordering rules. Distributions are first considered to come from the AAA. These distributions are tax-free to the extent of a shareholder’s stock basis, as the underlying income has already been taxed at the shareholder level. Once the AAA balance is exhausted, any subsequent distributions are considered to come from the AE&P.

Distributions from AE&P are taxable to shareholders as dividends, similar to C corporation dividends. This represents a second layer of taxation on income already taxed at the corporate level during the entity’s C corporation years. After the AE&P is fully distributed, any further distributions are considered a return of capital to the extent of a shareholder’s remaining stock basis, then as capital gains once the basis is fully recovered.

Built-In Gains Tax

Another tax implication for a C corporation converting to an S corporation is the Built-In Gains (BIG) tax. This tax prevents C corporations from avoiding corporate-level tax on appreciated assets by converting to S corporation status and then selling them. The BIG tax is imposed at the corporate level on gains from the disposition of assets that appreciated while the entity was a C corporation.

The BIG tax applies if an S corporation sells assets held when it was a C corporation, and those assets had a fair market value greater than their tax basis at the time of the S election. This tax is levied on the “recognized built-in gain,” which is the gain that would have been recognized if the corporation had sold all its assets at their fair market value on the S election effective date. The tax is imposed at the highest corporate income tax rate on the net recognized built-in gain.

The BIG tax applies to gains recognized within a specific “recognition period” following the S corporation conversion. This period is 5 years. If the S corporation holds onto appreciated assets beyond this recognition period before selling them, the BIG tax can be avoided. Examples of assets that can trigger BIG tax include real estate, equipment, inventory, and intangible assets.

Strategies for Managing Tax Consequences

Businesses converting from a C corporation to an S corporation can implement strategies to manage tax consequences associated with accumulated Earnings and Profits (E&P) and the Built-In Gains (BIG) tax. Proactive planning can reduce unexpected tax liabilities.

Regarding accumulated E&P, one strategy involves making distributions to shareholders while the entity is still a C corporation, if feasible. This can reduce or eliminate the AE&P balance before conversion, simplifying future S corporation distributions. Another post-conversion option is for the S corporation to elect to distribute AE&P first, before the Accumulated Adjustments Account (AAA). This election allows shareholders to intentionally recognize dividend income from AE&P, potentially clearing the balance and enabling future tax-free distributions from AAA. However, this strategy accelerates taxable income for shareholders.

Careful planning of S corporation distribution timing and amount helps manage taxable dividends from AE&P. Maintaining accurate records of both AAA and AE&P balances is important for proper tax reporting and distribution planning.

For the Built-In Gains tax, a primary strategy is to hold onto appreciated assets inherited from the C corporation period beyond the 5-year recognition period. By waiting until after this period to sell such assets, the gain recognized will not be subject to the BIG tax. Another approach involves offsetting recognized built-in gains with recognized built-in losses. If the S corporation disposes of assets that had a built-in loss at conversion, these losses can reduce the net recognized built-in gain subject to tax.

Accurate asset valuation at conversion is also important. A detailed valuation helps establish the fair market value and tax basis of all assets, providing a clear baseline for potential built-in gains and losses. Seeking professional tax advice is recommended throughout the conversion process and for ongoing tax planning.