Discussion:C CORP CONVERSION TO S CORP

the question I have to ask is as follows.

should we convert to "S" just because we want to avoid double taxation? What are the other issues that I have to be concerned, if I do convert? what about the appreciated value on the real estate? how should I plan for changing the year end to december 31st? I will appreciate your help.

1.Built-in gains tax on that appreciated real estate will haunt you for 10 years. Get an appraisal. If client sells the r/e before the 10 year period, you will need to know how much of the gain existed on the date of the conversion. Built-in gains tax will apply on other assets as well if sold prior to 10 year waiting period. If business is sold, goodwill may be one of the assets that will be sold, so you may wish to have an appraisal of the business that will nail down the goodwill and other asset values at the conversion date.

2.Existing accumulated earnings and profits. Consider paying them out prior to 2009. Good possibility the 15% tax rate on dividends will go away after Bush leaves office. If you make the S election, you can elect each year to pay out AE&P prior to AAA in order to liquidate the C corp retained earnings.

3.You'll likely kiss the fiscal year goodbye with the S election.

4.If you stay a C corp, you could retain $50-$75k of taxable income in the C corp each year to gain the advantage of the low corporate tax rates. As an S corp, all of the K-1 income will be piled onto the owner's other income and be taxed at the highest marginal rate. (As long as the 15% rate is available on dividends, leaving $50k in a C corporation to be taxed, followed by taking a taxable dividend will yield an effective tax rate of only 27.75%) With the appreciating r/e in the C corporation, this is not a strategy I would recommend, as the tax on the back end will be nasty.

5.Not too much to worry about the change to 12/31 year end. The 5/31 return will be an 1120, the 7 month period ending 12/31 will be an 1120S, so there will be no doubling up of K-1 earnings in the year of conversion.

Hope this helps.

Regarding the undistributed profits, one plan my clients like for small businesses is to accumulate enough profits as a C corp to finance working capital needs (i.e. to fund inventory, accounts receivable etc.), paying taxes at the lower C corporation rates. Then make the S election and draw all future profits out of the company - after all, getting profits out to the owners for their personal use is usually the ultimate plan, and is almost always cheaper in terms of taxes with an S corporation.

If the client doensn't want to convert to being an S corporation, at the risk of sounding like a broken record, you may want to address the issue each year, to avoid surprises later. After a few years, you will "own" the problem of the appreciated real estate.

Are we having fun yet?

Good luck!

It seems the primary reason to convert most C's to S's is for the back end - when you eventually sell the assets of the business you don't want to get hit with the huge double taxation that can result. When C's look at the tax results of being a C vs. an S at the back end (hopefully with a realistic 10-year horizon if they choose to convert) most C's will be in favor of converting, even if they have to suffer some extra taxation along the way.

1. What happens to Retained Earnings of C-corp in conversion? Does it become basis in S-Corp? Is it taxed as dividned if distributed within 10 years?

2. If C-corp is part of a controlled group, does that have any affect on converting to S-Corp?

Thank-you!

2. I don't think so...but all controlled group rules still apply as to fringe and pension plans.

you are saying no matter if you change from C to S corp, the R/E are going to be taxed at the dividend rate. Usually an S's distributions are not taxed but I am guessing since this prior R/E from the C-corp was never double taxed it is going to have to be even though it is in the S-corps R/E balance from the conversion.

Can be devastating if large receivables, such as may exist in a medical corporation.

One of the greatest long term problems is the fact that you have that real estate in the corporation which, most would agree, should never have been done.

I wonder if you'd be better off keeping the C-Corp for the business and spinning-off the real estate into a more favorable tax entity?

If liquidation is the ultimate goal and the real estate is the largest chunk of the company's assets, would your client be better off selling the C-Corp with the real estate still inside? If there are other parts of the business that your client wants to keep, those could be spun-back to the client as part of the stock sale.

As others have correctly noted, this is not an easy decision. The client needs to have a clear goal in mind before he opens this large can of worms.

FlaGators, membership in a controlled group will certainly have an effect on whether or not S status can be elected. First of all, an S corp cannot have a C corporation as an eligible shareholder. So if the corporation is the subsidiary, it cannot elect S status. However, if the parent wants to elect S status, the subsidiaries may be treated a "qualified S corporation subsidiaries" (QSUB). In that case, the subsidiary retains its separate legal identity but becomes a disregarded entity for tax purposes and files what is the equivalent of a consolidated return at the parent level.

On the issue of taxation of C corp dividends paid out after the S election is made, another point to remember is that Democrats have just taken over Congress and will likely take the presidency in 2008. Therefore there may only be a short window remaining for those C corp retained earnings to be paid out as dividends taxed at 15%. So any S corps with existing C corp retained earnings may want to consider making the election FTF refers to electing to have distributions from R/E to be taxed from AE&P (C corp R/E) first rather than from AAA (S corp R/E), so that the C corp R/E gets drained before the tax rates are increased.

to S status. Even intangibles.

Here is a quick PHC read from the New York State Society of CPAs Journal... http://www.nysscpa.org/cpajournal/old/14469571.htm

also, the C-corp has inventory and A/R, is there a BIG concern here? (AR is worth 50K and Inventory about 80K)

thank in advance.

Kbryan1014 - There are no balance sheet changes to these accounts.

John Huddleston

My client is a shareholder in a c-corp which holds rental real estate (not per my advise) and we are looking at the pros & cons of converting to an s-corp. My question is the valuation of the real esate upon the conversion. Do we record the real esate at the net book value at the time of transfer? We will not be distributing the real estate due to the BIG tax.

If BIG is paid on a C-S conversion, do the shareholders of the now S-corp get any A) Shareholder basis additions and B) does the AAA account get any addition for the BIG tax paid?

Any input would be greatly appreciated

Your answers below were most informative. I have one more. If, when and how can RE trapped in and C-S corp conversion be used for tax deductible purposes?

Thank you.

FlaGators (talk

If the homes are worth more than the cost there will be a realizable BIG on July 1, 2010. The BIG will be recognized in the year of sale UNLESS the corporation has no taxable income. The BIG could be recognized in each succeeding taxable year during the remainder of the recognition period unless there is no profit in each succeeding year.

As JR suggests, the built-in gain is the difference between the FMV of the houses as of the effective date of the S election and their adjusted basis. If a house is worth less than its basis at the date of the election, there would be a built-in loss, which could offset any other built-in gains. See IRC Sec. 1374.