C Corp to S Corp Conversion

From February’s Axiom on Value

The Window to Elect S Corp Status for 2015 Closes March 15

Many business owners are completely focused on the day-to-day operation of their business.  For these owners, issues of ownership transition planning and optimal tax strategy at the owner’s exit are “nice to consider” but will be irrelevant if the company does not make it through next month’s payroll.  CPAs for these businesses try to educate their clients on the long-run implications of staying as a C corporation, the de facto structure when incorporating, but often run into a variant of “why bother? In the long run, we are all dead”.

The decision whether to elect S corporation is a complex one, and should only be done after reviewing with your advisors the pros and cons of both corporate structures.  However, we note that according to IRS statistics, most “small” businesses chose the S form at some point in their stage of development, so it is an issue worth serious consideration if the owner expects to sell the business, rather than close it down upon retirement.

 Major Difference in Taxes Paid in an Asset Sale between a C and S Corp

The primary reason to consider electing S corporation status is that there can be a significant difference in the taxes paid on the sale of a business in an asset transaction between an S corporation seller and a C corporation seller.  (If the buyer is willing to buy the corporate stock, then there may be little or no difference in taxes paid by sellers of a C or an S corporation).   In an asset transaction for a C corporation, the gains on tangible and intangible assets are taxed at the corporate capital gains rate, which is 35% at the federal level.  Then, when the corporation closes down, it will distribute the remaining cash as dividends, which in most cases are taxable at the individual level.  The effective tax rate can exceed 55% of the gain in the C corporation assets.

The asset sale of an S corporation after 10 years following the S election will be taxed at a much lower rate, since the capital gains are taxed at the individual capital gains rate, and there is no tax on distributions.

The 10 Year Window for the BIG Tax 

For companies that elect S corporation status, there is a 10 year window following the election when the C corporation tax structure will apply to the value created as a C corporation.  The IRS imposes a “Built-In Gain (BIG) tax on the gain in value of the company’s assets as of its conversion from C to S.  The gain in value over the value as a C corporation is taxed based on the S Corp rules.  Consequently, it is necessary to determine the value of the company and its tangible and intangible assets in their C status as of the conversion date.

If S Election is Made, a Business Valuation Should be Done

The valuation should be done using the conversion date as the effective date.  This valuation will be based on the financial statements of the business up to the conversion date, and on the outlook for the company as of the valuation date.

The valuation should determine the total fair market value of the business.  For larger companies, there should be an additional analysis to allocate the total asset value over specific tangible and intangible assets, in case there are sales of specific assets during the 10 year window.

This valuation will not be filed with the IRS upon its completion.  The valuation will stay with the corporation and its CPA for use in the tax calculations, if there is a sale of assets or the business during the 10 year window.  Having the valuation done just after the conversion date is the best way to maximize the rewards from building and operating a privately held business.

 S Corporation Basics (from IRS publications)

S Corporation Requirements

To qualify for S corporation status, the corporation must meet the following requirements:

– Be a domestic corporation
– Have only allowable shareholders
* May be individuals, certain trusts, and estates and
* May not be partnerships, corporations or non-resident alien shareholders
– Have no more than 100 shareholders
– Have only one class of stock
– Not be an ineligible corporation (i.e. certain financial institutions, insurance companies, and domestic international sales corporations).

Steps to Elect S Status:

Complete and file Form 2553:  No more than two months and 15 days after the beginning of the tax year the election is to take effect, or at any time during the tax year prior to the tax year the conversion is to take effect.