S Corporation to C Corporation Conversion: Opportunity Available, but Perils Remain

Does it make sense for an S corporation to convert to a C corporation in light of last year’s Tax Cuts and Jobs Act? The Act provides a flat 21% tax rate for C corporations. It also changes some rules for S corporation to C corporation conversions. However, potential pitfalls remain.

S Corp Conversion Changes Under the Tax Cuts Act

The Tax Cuts and Jobs Act (TCJA) includes two changes that apply when an S corporation revokes its S election and becomes a C corporation. The TCJA changes:

  • the adjustment period for changes of accounting method; and
  • the treatment of distributions from the C corporation.

These changes apply to a C corporation when three conditions are met. The new C corporation:

  1. was an S corporation on December 21, 2017;
  2. revokes its S corporation election after December 21, 2017, but before December 22, 2019; and
  3. has the same owners of stock in identical proportions on the date of revocation and on December 22, 2017.

Six-year Adjustment Period

The corporation should report net adjustments attributable to revoking its S election over six years. The six-year adjustment period begins with the year of change. The six-year adjustment period is:

  • required for terminated S corporations that must adopt accrual accounting because of the termination; and
  • optional for terminated S corporations that are permitted to continue to use the cash method but chose to change to the accrual method.

Distributions by the C Corporation

Distributions of cash after the post-termination transition period, which is generally one year, may be treated as coming proportionally out of the corporation’s:

  • accumulated adjustments account; and
  • accumulated earnings and profits.

As a result, part of the distributions will be non-dividend distributions from the C corporation. A shareholder with sufficient stock basis may not be subject to shareholder-level tax on these distributions.

Disadvantages of S corporation to C corporation Conversion

Potential disadvantages for S corporation to C corporation conversions remain.

Double Taxation

C corporations are still subject to double taxation. First, the corporation pays corporate tax on its earnings; then the shareholders are taxed on dividends. An S corporation does not pay corporate tax in most cases. Its income and losses are “passed through” to shareholders on their personal tax returns.

Qualified Business Income Deduction Not Available

The TCJA not only lowers the corporate tax rate; it also provides owners a deduction of up to 20 percent of domestic qualified business income from a partnership, S corporation, or sole proprietorship. C corporation income does not qualify for this deduction.

Potential Additional Tax if the Corporation Converts Back

S corporations that were C corporations may be subject to:

  • Built-in gains tax—this is a corporate-level tax on gain from certain property sales made after a C corporation elects to become an S corporation.
  • Net passive investment income tax—this tax applies to S corporations with earnings and profits accumulated while a C corporation.

Since there is no certainty that the lower corporate tax rate will remain, taxpayers and tax professionals should not overlook these potential additional taxes when considering conversion from S corporation to C corporation status. They should also review and consider other potential advantages and disadvantages of S corporation and C corporation status before making a decision.

By Robert Recchia

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All stories by: CCHTaxGroup