When considering converting from an S Corp to a C Corp, there are important factors to review, including the advantages of each type of entity, the reasons why an owner may want to convert, what the conversion process from an S Corp to a C Corp looks like, and what the impact of a C Corp conversion is.
Advantages of an S Corp
Some of the advantages of an S Corp include:
Ability to Offset Income Taxes
With an S Corp, business earnings are taxed at the personal tax bracket level since they are reported on the personal tax return. This is a huge advantage, especially for larger S Corps that have a lot of taxable income at the end of the year. If certain qualifications are met, it’s possible for taxable income to be reduced by 20%, using the QBI (Qualified Business Income) deduction. [1] The ability to offset income taxes includes the ability to offset other forms of income on the personal tax return if there is a tax loss from the S Corp.
Preferred Tax Rates
Certain gains passed through from an S Corp to individual shareholders can be eligible for preferred tax rates. For instance, capital gains received by shareholders from the sale of assets held by the S Corp for more than one year are taxed at the long-term capital gains rate, which is lower than ordinary income tax rates.
Tax-Free Distributions
With an adequate tax basis and a positive AAA (Accumulated Adjustments Account), an S Corp can distribute money to its shareholders tax-free to the extent of their stock basis. Stock basis in the S Corp increases in relation to undistributed earnings, which can add value if the S Corp seeks a sale in the future.
Reduced Personal Liability
An S Corp entity provides a shield against personal liability for its shareholders in the event of a business liability claim. This means that shareholders are generally not personally responsible for the debts and liabilities of the S Corp. Distributions, earnings, and contributions to shareholders are typically made on a pro-rata basis according to the percentage of ownership, which simplifies the allocation of income and distributions within the S Corp.
Advantages of a C Corp
There are also substantial benefits of a C Corp. These include:
C Corp Taxes Aren’t as High as Before
When the TCJA (Tax Cuts and Jobs Act) tax law [2] passed in 2017, things changed for C Corp taxpayers. It meant that the C Corp tax rate of 21% was actually lower than the highest individual tax rate of 37%, or, if the taxpayer used the highest benefit of the QBI deduction, 29%.
State Taxes Can be Deducted Uncapped
A C corporation can deduct all state taxes, while individuals paying state taxes on S corporation earnings face a $10,000 cap on their itemized deductions. However, if the earnings are from states that allow the S corporation to take a deduction, this cap does not apply. This requires having an election, and not all states offer this option.
Raising Capital is Easier
With a C Corp entity, there are no limitations on the types of allowable owners, and there can be an unlimited number of owners. This typically makes it easier if the C Corp wants to raise capital.
Why Convert from an S Corp to a C Corp?
What reasons might an owner or owners have for converting from an S Corp to a C Corp? It turns out there are several smart reasons to make this conversion.
One of the biggest reasons why owners convert from an S Corp to a C Corp is the potential for tax savings. At the state level, C Corps can deduct 100% of state taxes, while S Corps have a $10,000 cap on state tax deductions unless a special election has been held in that particular state to remove the cap. This reason is a top priority for C Corps operating in states with higher tax rates. But the advantages don’t stop there.
Another common reason for making the conversion from an S Corp to a C Corp is the flexibility in raising capital. With a C Corp, multiple classes of stock can be issued, a broader range of investors can be attracted, and those investors can include venture capitalists and institutional investors, who typically prefer investing in C Corps over S Corps.
It’s easier to grow a C Corp than an S Corp since C Corps can retain and reinvest earnings within the entity, which may reduce the tax burden on the owner and shareholders. Finally, the corporate structure of C Corps can be more favorable for employees’ stock options and other incentive plans. This can help attract and retain top talent by offering more attractive compensation packages.
How to Convert Your Business from an S Corp to a C Corp
If you’re looking to convert S Corp to a C Corp, here are the steps you would need to take. Note that there is no standard form for changing your company’s tax status from an S Corp to a C Corp. But there are still important tasks to fulfill.
Hold a Meeting
Shareholders and directors (if any) should meet to approve the change from an S Corp to a C Corp. This agenda item can be on a special meeting, or it can be part of the annual meeting agenda; it doesn’t matter to the IRS. Make sure that the meeting minutes reflect the vote.
Amend Articles of Incorporation
You may need to amend your Articles of Incorporation to reflect the new status as a C Corp. This involves filing the necessary paperwork with your state’s Secretary of State office. Requirements can vary by state, so ensure you comply with local regulations. Consult with your CPA if you have any doubts.
Update By-laws
You should also review and possibly update your corporate bylaws and shareholder agreements to align with the C Corp structure. This includes addressing changes in stock issuance, voting rights, and other governance matters. Ideally, this should be another item on the agenda, so all stakeholders are in agreement with the changes.
Impacts of a C Corp Conversion
The tax impact of a C Corp conversion is substantial, which is likely a big part of the reason why an owner decides to do it in the first place. For that reason, it’s often helpful to conduct the conversion right at the end of a tax year. That way, the following year can be treated wholly as a C Corp. This simplifies things on the accounting end and makes the entire conversion and its subsequent tax changes a lot less confusing for shareholders.
