Tuesday, September 4, 2012

Converting your C-Corp - It may be now or never

You may have recently considered the pros and cons of converting your C Corporation to an S Corporation or LLC.  The Tax Adviser recently included a detailed article emphasizing that now may be the time.  So why is now a critical time?  I'm so glad you asked:

  • Due to the extended Bush tax cuts, tax rates are currently at historic lows.  These rates once again are set to expire at the end of this year.  With great uncertainty in a presidential election year, we cannot count on the tax cuts being renewed.
  • Unfortunately real estate values are also at historic lows.  Because converting a C corporation to a passthrough entity (partnership or S Corporation) can trigger gain based on the fair market value of the corporation’s assets, lower real estate value can be a good thing from a tax standpoint. 

Once you come to the decision (and work up the nerve) to convert your C Corp, you must decide between an S Corporation or LLC.  Both forms are passthrough entities - meaning income will be passed through to the individual level and will be reported and taxed when you file your individual tax return.

Converting to an S Corporation is easier and less costly than converting to a LLC.  I’m assuming you are now thinking “OK - stop right here.  Why would I even consider converting to a LLC?”  Depending on your corporation’s current needs and future goals, converting to an S Corporation may not be desirable (or even possible).  Here are a few basic rules for becoming an S Corp:

  • It must be a domestic corporation.
  • The corporation cannot have more than 100 shareholders.
  • Shareholders can only be individuals who are US citizens or residents, certain estates, certain trusts, and certain tax-exempt organizations (i.e. partnerships cannot be a shareholder in an S Corp).
  • The corporation can only have one class of stock outstanding.  Special allocations of earnings to certain shareholders can create a separate class of stock, which will revoke the corporation’s S election.  Generally, all shareholders will need to have identical rights to distributions and liquidation proceeds.

Usually the “one class of stock rule” is the most challenging limitation for our small C Corp clients.  Transactions such as compensation arrangements and leases between the corporation and shareholder can violate the "one class of stock" requirement.

Every business is unique.  This brief discussion by no means describes all of the issues you will need to consider when converting your C Corp.  If you have any questions, please don’t hesitate to contact one of our tax specialists at Robinson Grimes.

Jessica Miles, CPA