For some small businesses, switching to an S-corporation entity structure from a C-Corp can reduce federal employment taxes. Despite the financial savings your company can enjoy while operating under this new classification, there are some additional taxation liabilities to keep in mind before making this change.
To better understand how your business could be impacted by converting to an S Corp formation, check out this quick overview of the issues you might face:
Passive Income
S-corporations may be liable for tax related to any passive income that exceeds a 25% threshold of their gross receipts and revenue and profits carried over from their former C-Corp status. This classification includes income such as:
- Dividends
- Royalties
- Profitable stock sales
You could lose your S-Corporation classification if your company owes this tax for three consecutive years or more. This scenario is avoidable by distributing profits and earnings your business accumulated and letting shareholders pay their share of the owed taxes. If this isn't an option, you may consider avoiding this tax by capping how much passive income can be earned.
Tax Loss Carry Forwards
Suppose your C-Corp had experienced operating losses before switching and didn't apply it to reduce taxable income. In that case, it can't then be applied to your S-Corp as an offset to its income or get passed along to your shareholders. This is why you should first determine whether it's worth forfeiting these tax savings for those you'll enjoy as a company with an S status.
LIFO Inventories
If your C-Corp uses the LIFO inventory method, plan on paying taxes on that benefit if you convert to an S-Corp. While you can spread this cost over a four-year period, carefully consider if the possible gains you will receive as an S status are worth this additional expense.
Built-in Gains Tax
When converting to a C-Corporation from an S, you will have to pay a built-in federal gains tax on your appreciated assets and profits for this changeover. This applies if you have recognized gains within the first five years of becoming an S-Corporation. While this may not be ideal, if your decision to switch will ultimately have improved tax benefits despite this taxation, you may opt to continue with your plans.
These potential factors that could impact your decision to change your corporation status from C to S are the most common, but not the only ones you should consider. You also have to keep in mind that any shareholder-employees you have under an S-Corp structure won't have the same tax-free benefits as before, and those who have outstanding loans could complicate things further.
There are several options companies have at their disposal to mitigate or completely eliminate some of the tax issues mentioned above. Avoiding some of the unnecessary pitfalls related to these solutions is also important and doable with the right planning. Ultimately, much depends on how you run your company and any special circumstances that might be at play. Contact us to discuss the effect of these and other potential problems, along with possible strategies for dealing with them.