Converting from a C Corp to an S Corp

As you may know, there are two types of corporations for tax and legal purposes. The "C" corporation is a more formal structure than the "S" corporation and taxed differently.

Converting from a C Corp to an S Corp

When forming a business entity, many people just rush out and file whatever sounds good. Occasionally, they may break down and read an article or two on the web. When it comes to corporations, this can lead to serious problems. The problems arise in the form of how taxes are paid.

A "C" corporation is the oldest business entity we have. It is a very formal structure requiring accurate minutes and record keeping. From a tax perspective, it is very cumbersome as the IRS and state tax agencies treat it as a separate entity for tax purposes. This means that the entity is responsible for paying taxes on its gains. The money shareholders then receive is also taxed on their personal returns. This leads to the "double tax" scenario most people reference when criticizing "C" corporations as a business choice.

An "S" corporation is a more informal business structure. It is designed to be used by smaller businesses that do not want to deal with the formality of the C corp. For tax purposes, it is considered a pass through entity. Instead of the S corp paying taxes on its gains, it simply passes them through to the shareholders who report the financial information on their tax forms. As a result, the doubt tax problem with the C corp is solved.

Given the above scenario, many people with C corps often desire to convert to S corps to get a better tax situation. First off, it most certainly can be done. While that is true, there are some potential pitfalls that have to be addressed. Let's take a closer look.

When converting from a C to an S, certain assets owned by the C corp get special tax treatment. When I say "special", I mean bad. Any property owned by the C that has appreciated is taxable as a capital gain if the gain is realized within 10 years. For C corps with inventory, the use of LIFO inventories results in an immediate tax although it can be spread over four years.

One of the real killers of the conversion has to do with losses. If the C corp is carrying losses on the books it is using to offset revenues for tax purposes, converting may be a bad idea. Why? The losses are voided when the conversion happens. In simple terms, this means neither the S corp nor its shareholders can claim them. If you have substantial losses in your C corp, you need to consider whether converting to an S makes sense.

At the end of the day, there are many ways to deal with the double tax C corp problem. One can simply expense out all revenues for example. If you are convinced you would be better off converting to an "S" corp, make sure you get ample tax advice before doing so! Otherwise, you could really regret the decision.

Richard A. Chapo is with SanDiegoBusinessLawFirm.com - providing California incorporation services.