One of the most challenging tax reform questions facing privately held businesses is whether to convert from an S corporation to a C corporation to receive the benefits of the new 21% corporate tax rate. As in all things tax, there is no one-size-fits-all answer, but once you’ve made the decision to convert, here are the key tax issues for you to consider.
Distribute S corporation earnings before conversion
C corporation earnings are subject to two taxes: an entity-level tax and a shareholder-level tax when the earnings are eventually distributed. In contrast, a pass-through entity’s earnings are generally not subject to an entity-level tax. Instead, the earnings pass through on Schedule K-1 and are reported on the owner’s personal income tax return. The pass-through entity can then distribute those earnings on a tax-free basis.
If a corporation was a C corporation and subsequently became an S corporation, the corporation is required to track the amount of its retained earnings attributable to S corporation years and the C corporation years to determine whether distributions are a tax-free distribution of previously taxed earnings, or a taxable dividend. S corporation retained earnings, measured on a tax basis, are tracked in what is called an accumulated adjustment account (AAA).
Before converting an S corporation to a C corporation, you should consider whether to distribute previously taxed S corporation earnings to avoid the dividend tax on C corporation distributions. But what if you don’t have cash available to distribute the balance sitting in an AAA prior to revoking your S corporation election?
An S corporation can distribute its AAA balance by issuing a note to its shareholders before converting to a C corporation. Note payments are tax free to the recipient, even after the corporation becomes a C corporation. The note must be clearly evidenced and be respected as debt for tax purposes. Courts evaluate several factors in determining if a note should be respected as debt for tax purposes, including whether:
- There was a note or other evidence of a promise to repay
- Interest was charged
- A fixed schedule for repayment was established
- Collateral was given to secure payment
- Repayments were made
- The borrower had a reasonable prospect of repaying the loan and whether the lender had sufficient funds to advance the loan
- The parties conducted themselves as if the transaction was a loan
You should consult with an attorney to draft the note and issue the note prior to the effective date of the revocation of the S election. You will also need to consider the effect of the note payable on your balance sheet and make sure it won’t create issues with your creditors.
How to revoke your S Corporation election
An S corporation can convert to C corporation status effective as of any date going forward. Keep in mind, two tax returns are required if the revocation is made in the middle of the year: a short-year S corporation return for the first part of the year and a short-year C corporation return for the last part of the year. Further, revocation of S status can be effective retroactive to the first day of the current tax year if done within the first 2.5 months of that year (i.e., a calendar-year S corporation has until March 15, 2018, to revoke its S status, effective January 1, 2018).
If a corporation’s status as an S corporation has been terminated, it generally must wait five tax years before it can again become an S corporation. The S election is revoked by filing a statement with the IRS signed by shareholders owning more than 50 percent of the outstanding stock indicating that the corporation is revoking its S election. Specific language should be used, and in some instances, spouses of shareholders need to sign the revocation as well, so it is best to work with your CPA to prepare the revocation.
Distribute S corporation earnings after revoking the S election
If you didn’t distribute your S corporation earnings before revoking the S election, there may still be time; distributions made within one year of the revocation are generally treated as distributions of previously taxed S corporation earnings. One trick, however, is that the distributions have to be made with cash — the note distribution strategy is effective only if the note is distributed before the S election is revoked.
Congress recognized that many corporations would convert to C corporations in response to the reduction in tax rates and adopted special rules for corporations that were S corporations on the effective date of tax reform, December 21, 2017, and revoke their election during the two-year period beginning on December 22, 2017.
To be eligible for the special rules, there can’t be any changes to the ownership of each of the shareholders between December 22, 2017, and the time of the revocation (i.e., each of the shareholders needs to remain a shareholder and continuously hold the same ownership percentage). If an eligible corporation makes a cash distribution after the one-year period, the distribution is treated partially as a tax-free distribution of S corporation earnings and partially as a dividend form C corporation earnings in the same ratio as the amount that the AAA account bears to the amount of accumulated C corporation earnings. This benefit applies only if the S corporation revokes its election, not if the election is terminated by disqualifying the corporation from being an S corporation.
If you are considering converting your S corporation to a C corporation, you should determine whether it is appropriate to distribute the S corporation earnings before you revoke the S election, taking into account the cash flow needs of the business. Establishing a note for all or part of the balance of AAA before revocation provides an opportunity for owners to manage cash flow and minimize the risk of double taxation.
If you already converted to a C corporation, you should consider whether there is an opportunity to classify part or all of your distributions as a tax-free return of previously taxed earnings. CLA can help you evaluate whether you should convert and plan for the related consequences.