S corporations can provide significant tax advantages over C corporations in the right circumstances. But there are a number of potential tax problems that you should assess before making a decision to convert. Below is a summary of the most significant of these for you to consider.
Built-in gains tax. S corporations generally are not subject to tax. But those that were formerly C corporations may be subject to tax on unrealized "built-in" gains that the C corporation has at the time the S election becomes effective. These built-in gains are subject to tax if those gains are recognized within 10 years (7 years for tax years beginning in 2009 or 2010; 5 years for tax years beginning in 2011) after the corporation becomes an S corporation. Recognition of built-in-gain generally is unfavorable, but there can be situations where making an S election can produces a better overall tax result despite the built-in gains tax.
LIFO inventories. C corporations that use LIFO inventories have to pay tax on the benefits they derived by using LIFO if they convert to S corporation status. The tax can be spread over four years. This cost must be weighed against the potential tax savings from converting to S corporation status.
Passive income. S corporations that were formerly C corporations are subject to a special tax if passive investment income (dividends, interest, rents, royalties, and stock sale gains) exceeds 25% of gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. If this tax is owed for three consecutive years, the corporation's election to be an S corporation terminates. This tax can be avoided by distributing the accumulated earnings and profits as taxable dividends to the shareholders or by avoiding recognition of passive income.
Unused losses. If a C corporation has unused net operating losses, the losses cannot be used to offset its income as an S corporation, and cannot be passed through to shareholders. If the losses cannot be carried back to an earlier year, it is necessary to weigh the cost of giving up the losses against the tax savings expected to be generated by the conversion to S status.
There are other factors to consider in switching from C corporation to S corporation status. For example, shareholder/employees of S corporations can't get the full range of tax-free fringe benefits that are available with a C corporation. All of these factors have to be considered to understand the full effect of converting from C to S status.
Please give me a call or email if I can help you evaluate whether you should convert your C corporation to an S corporation. Jsenney@pselaw.com or 937-223-1130.
AND ONE MORE THING. Many businesses have been improperly classifying employees as independent contractors. The reason? Classifying workers as contractors rather than employees can save an employer 20-30% of its labor costs. The IRS has voluntary worker classification program that will allow businesses to reclassify their workers as employees, and pay only a small amount to cover past payroll taxes. However, the IRS also announced plans to aggressively audit and look for worker misclassification in the future. Give me a call if you have any questions about whether your workers can or should be treated as employees or independent contractors. Jsenney@pselaw.com or 937-223-1130.
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