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Tax Challenges during C Corporation to S Corporation Conversion

Under the right circumstances, S corporations may provide significant tax advantages over C corporations, thus prompting many business owners to convert to the former. However, this conversion can foster a number of potentially costly tax challenges that should be assessed during the decision-making process. Four of the more significant challenges include:

  1. Built-In Gains Tax: Though S corporations generally aren’t subject to tax, those that were previously C corporations are taxed on built-in gains—such as from the sale of appreciated property—that the C corporation had when the S election became effective. Built-In Gains Tax may apply for up to 10 years after the conversion depending on the year of the gain recognized.
  2. LIFO Inventories: C corporations that use LIFO inventories as their accounting method pay tax on the benefits they received by using LIFO if they convert to S corporations, which can be spread over four years. This cost should be weighed against the potential tax gains from converting to an S corporation status.
  3. Passive Income: S corporations that were previously C corporations are subject to a tax if their passive investment income—such as dividends, interest, rents, royalties and stock sale gains—exceeds 25 percent of their gross receipts, and the S corporation has accumulated earnings and profits carried over from its C corporation years. Passive Income Tax over a three-year period can result in automatic termination of the S election.
  4. 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. So, if the losses cannot be carried back to an earlier C corporation year, it’s necessary to weigh the cost of giving up the losses against the tax savings expected by the conversion to an S corporation.

These tax challenges while converting from a C corporation to an S corporation are just a few of many factors to consider while making this important decision. There are strategies for eliminating or minimizing some of these challenges, but those strategies are highly dependent on a company’s unique situation. If your company is considering a C corporation to S corporation conversion, discuss it with your tax adviser.

This publication contains general information only and Sikich is not, by means of this publication, rendering accounting, business, financial, investment, legal, tax, or any other professional advice or services. This publication is not a substitute for such professional advice or services, nor should you use it as a basis for any decision, action or omission that may affect you or your business. Before making any decision, taking any action or omitting an action that may affect you or your business, you should consult a qualified professional advisor. In addition, this publication may contain certain content generated by an artificial intelligence (AI) language model. You acknowledge that Sikich shall not be responsible for any loss sustained by you or any person who relies on this publication.

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