Running your business as an S corporation has several tax benefits. However, it’s hard to raise money in an S corp because you can only have one class of stock and you cannot have entity shareholders. So what do you do when you want traditional investors? One alternative is to convert to a C corp.
The good news is the conversion of an S corp to a C corp generally causes no tax. And it’s easy to do.
Conversion Methods
Here are three ways you can convert from an S corp to a C corp:
- Submit a revocation statement to the Internal Revenue Service, as explained in more detail here;
- Simply violate an S corp rule, for example, by issuing preferred stock, in which case the entity immediately becomes a C corp; or
- Form a new C corp and merge the current entity into it, with the C corp surviving.
For those of you who are familiar with the rules that apply to the conversions of entities taxed as partnerships to C corporations you may be aware of a tax trap involving liabilities in excess of basis. Fortunately, that rule generally does not apply to S corp to C corp conversions (but see the exception under the QSBS discussion below).
Here are some additional tax considerations:
Is Your Entity Really an S corp?
It’s usually worth spending some time confirming that the current entity is actually an S corporation. The quick version of that is asking: From the time the company made the S election until now did it meet each of the following requirements?
- Only one class of stock;
- Less than 100 shareholders;
- No nonresident alien shareholders (including spouses in community property states); and
- No entity shareholders (subject to certain exceptions).
In addition, if it’s an LLC that elected S status one should take a good long look at the operating agreement of the entity. Traps for the unwary including forgetting to remove things from the LLC agreement at the time the S election is made like a return of capital contributions prong in the distribution waterfall. Such an oversight can blow the one class of stock requirement, because it creates a preference for shareholders who contributed capital.
Qualified Small Business Stock (QSBS)
Will the C corporation qualify as a qualified small business? See here for a checklist.
If the new C corp will be a qualified small business, be warned that the C corp stock received by the historic S corp owners will not be QSBS, because there is a requirement in tax code Section 1202 that QSBS is stock issued for property “other than stock.” This is the result regardless of whether (i) the S corp voluntary revokes its election, (ii) the S corp election is terminated by operation of law, like by issuing preferred equity, or (iii) the S corp contributes assets to the C corp and then distributes out the C corp stock to the S corp shareholders.
A way to receive QSBS treatment for the current owners would be to set up the new C corporation, and have the S corp contribute its assets into the new C corp in exchange for stock but then not distribute the C corp stock. The S corp would need to continue holding the C corp stock until a sale of the C corp, at which point, if the C corp stock was held for more than 5 years and certain other requirements were met, the S corp owners could receive the beneficial 0% federal tax rate on the income passed through, to the extent they owned their interest in the S corp at the time the S corp acquired the C corp stock. Investor purchases stock of the new C corporation directly and such stock can be QSBS to the investor, assuming the investor is not a C corporation (a C corporation cannot own QSBS).
Be warned that if this C corporation as a subsidiary path is taken, that suddenly the debt in excess of asset basis test becomes relevant. Specifically, if the S corp contributes both assets and liabilities to the new C corporation, the excess, if any, by which the liabilities exceed the tax basis in the contributed assets will cause the S corp taxable income.
Allocation of Income
Upon termination of the S election, there is basically a choice to either allocate income between the S and C portions of the year on a daily pro rata basis or to close the books as of the last day of the S period. If nothing is done, then the first method of allocation applies, but the shareholders can elect to use the closing of the books method as long as all agree, including any new shareholder joining on the first day of the C year. Closing the books could be more favorable for the existing shareholders if, for example, the company has been running losses to date but then becomes profitable thereafter – by closing the books, the existing shareholders will have a larger loss than if the entire year’s results are prorated.
Other Considerations
- For S corps that have extra cash on hand, it can make sense to pay out cash pre-conversion, because after the conversion it could be a taxable dividend, though there is a concept of an accumulated adjustment account which allows under certain circumstances distributions post-conversion that result first in a return of basis.
- Finally, such a conversion can force the corporation on to accrual method tax reporting when previously cash method was permissible and used. That’s because pass-through entities like S corps generally can use the cash method of accounting, but a C corp with more than $25M of average annual gross receipts is required to use the accrual method.
Mike Baker frequently advises with respect to S corp to C corp conversions. He possesses a breadth and depth of experience in tax and employee benefits & compensation law that spans multiple decades. For additional information, please contact mike@mbakertaxlaw.com.